Election euphoria fades as investors focus on Cameron's challenges

A euphoric market reaction to the Conservative party's unexpected general election victory could soon prove fleeting as investors focus on looming challenges, a referendum on the UK's role in Europe and Scotland's presence in the union.

Relief swept across UK markets in the wake of the election result, led by surging equity prices, a firmer currency and lower government bond yields. The FTSE 250 share index of smaller domestic orientated companies rose above 18,000 to an all-time peak on Friday.

Such a performance, however, may prove difficult to sustain, as investors start gauging the risk associated with the upcoming referendum on the UK's membership of the European Union - now due by 2017, which raises the prospect of a British exit or "Brexit" from the EU.

London's longstanding status as a global financial centre has in part reflected its role in attracting talent from Europe and being a trading and commercial entry point into the single market.

Uncertainty in the next few years over the country's future role in the eurozone stands to undermine the City and also pressure UK asset prices.

"A hypothetical Brexit would probably not stop the City being the international financial hub," said Koon Chow, macro economics and foreign exchange strategist at Union Bancaire Privee. "Bouts of economic weakness and financial market turbulence have not hurt New York's status.

"But it would certainly raise questions about why some firms would still want to be based in London, which in turn affects financial trading volumes."

Nigel Green, founder and chief executive of Devere Group, the independent financial consultant, called Friday's rally "the calm before the storm" and added: "The prospect of an in-out referendum of Britain's EU membership has gone from risk to a reality.''

Fabrice Montagne, analyst at Barclays, said the "initial short-term cheer" on the markets "could be followed by a medium-term downside chill".

He added: "The EU referendum is likely to generate a substantial amount of uncertainty, particularly if polls fail to show more substantial support for EU membership in the coming weeks and months.''

For investors, there are uncomfortable parallels with the April 1992 general election when the Conservatives secured an unexpected and slim majority in the House of Commons.

Equities and sterling rallied sharply for a time but, later that year, the pound was forced out of Europe's Exchange Rate Mechanism (ERM), or the Black Wednesday sterling crisis.

Simon Derrick of BNY Mellon has no doubt that Brexit will be a major issue as the new government takes shape, but he questions how much sterling will be affected.

"The EU will be front and centre of a lot of discussion, including what it will mean for the eurozone - no question. Short-term, Brexit could weigh on sterling but that will fade," said Mr Derrick.

As an open economy running large external deficits, the UK is reliant on foreign investment flows, with both the currencies and bond markets seen as being vulnerable to any shift in sentiment.

However, Mr Derrick said he is not convinced international investors "get anywhere near as worried" as the British about the EU.

Adam Chester, head of economic research and market strategy at Lloyds Bank, said: "We need to see details on the timing and the form of the question before it starts to exert full influence on the markets.

"In the near term, the pound could come off a little bit but largely due to the return of the 'strong dollar' story. We think sterling will stay in the $1.45 to $1.55 range over the coming months, not materially away from where we are now."

Beyond the question of Brexit, the Conservative-led UK government stands to face a test after the Scottish National party won an unprecedented landslide victory in Scotland.

That potentially sets in train efforts by the government to offer further devolution in an effort to keep the UK together, or another vote on Scottish independence.

Caroline Simmons, strategist at UBS, said: "The big win in number of seats for the SNP brings scope for greater devolution. Full fiscal autonomy cannot be ruled out, which could raise additional questions about the UK's fiscal position over the medium term."

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