With the election looming ever nearer and the possibility of an unstable coalition growing, investors will need to keep an eye on sterling.
Those tasked with analysing elections suggest there are eight potential outcomes in terms of political bedfellows as the likelihood of a hung parliament becomes an increasingly realistic result.
Perhaps the most important knock-on effect of the election outcome is whether there will be a referendum on the UK’s membership of the European Union (EU).
This has been earmarked for 2017 by the Conservative party, but should it win there is the possibility of this being brought forward to help remove uncertainty.
Toby Nangle, global co-head of multi-asset and head of asset allocation, Europe, Middle East and Asia, at Columbia Threadneedle Investments, says a potential exit is a “bit of a worry” even though he has assigned it as a “low-probability” event.
However, he did draw parallels with last year’s Scottish referendum in terms of the impact on sterling against the dollar.
Mr Nangle says prior to the Scottish vote, implied volatility spiked up from about 5 per cent to 11 per cent. On one-month forward implied volatility, sterling now sits at roughly 13 per cent, the highest since 2010.
“There is a big increase in the uncertainty with how sterling will trade and there could be risk premia attached to that,” he says, calling it “the clearest signal there is some electoral uncertainty priced into sterling”.
But he says the huge current account deficit – “the biggest in the post-war period” – could also be weighing on the pound.
Kathleen Brooks, a research director at Forex.com, agrees the in-out debate is “one of the hottest topics during this election”.
“The rise of anti-EU party UKIP has focused minds on whether the UK should stay in the EU,” she says.
“The Conservatives, which have a powerful anti-EU faction, have promised to hold an in-out EU referendum in 2017 if they win power. However, a potential referendum could be pushed forward if they were to join a coalition with UKIP.”
Ms Brooks continues: “The Labour party has not committed to a referendum on UK EU membership, so this may only be an issue if we see a Tory government or a Tory-led coalition. This could be the biggest concern for the foreign exchange market in the aftermath of the election.
“Since a referendum is unlikely to be scheduled for a few years, it could lead to a protracted period of weakness for sterling.”
Nick French, head of UK wealth management at Russell Investments, says he always aims not to expose clients to “unnecessary and unrewarded risk”, which is “how we are approaching the UK general election”.
“The one thing we can be reasonably sure of is that the volatility in domestic markets and sterling will increase as a result of election uncertainty,” he says.
“This increase in volatility is already beginning to manifest itself in option implied volatility across asset classes.
“From our vantage point, it is not clear that the market is pricing in the full extent of the uncertainty or a long enough window. It seems likely that volatility, particularly in sterling, will be more pronounced and last for a longer period of time after the election date.”
The potential for an ill-fitting coalition could also create a rise in volatility for sterling, as well as for other UK asset classes.
John Bilton, global head of multi-asset strategy at JPMorgan Asset Management, says: “One of the attractions of UK assets to international investors has traditionally been their perceived safe haven status – in large part reinforced by robust property rights and a predictable parliamentary system.
“Fundamentally, while either a two-party or multiparty system is perfectly legitimate and functional, the structural transition from one to another is not without risks and tensions.”
But it isn’t all doom and gloom. Stephen Jones, chief investment officer at Kames Capital, says the equity market has “priced in all the uncertainty”.
Mr Jones says the equity market is supported by strong economic data “that doesn’t appear to be coming under too much threat either from the election campaign or the policies of the main parties”. He adds the common ground between Labour and Conservative manifestos has helped reassure market sentiment.
On bonds, he says the 150 basis point spread between 10-year gilts and German bunds – which are well supported by the European Central Bank’s quantitative easing programme – suggests any UK political uncertainty has also been factored in.
Steven Bell, chief economist at F&C Investments, says the strength in putting in place a tough fiscal policy sooner rather than later will be more critical than the “colour” of the election outcome.
“When you gain office you must be very tough in the first two years on your economic policy so that you can relax in the second half and get re-elected,” he says.
“If not, you end up having a mid-term crisis and you lose office.”
He adds almost every government since Margaret Thatcher – bar the incumbent – has taken this approach for their successive wins.
Mr Bell adds that potential spending cuts by whichever government is elected could “push out even further the prospect of an interest rate rise”, which may mean gilt yields remain attractive on a relative basis and continue to attract investment and thus support the UK.
