Political Unknowns Lurk for U.K. Risking Favor With Markets

Political danger is looming for Britain, threatening to dim the allure of the fastest-growing Group of Seven economy.

An election in less than 10 months could clear the way for Britain to leave the European Union, its biggest trading partner, if David Cameron remains prime minister. In September, Scotland votes in an independence referendum that threatens to rend the U.K. asunder. All this comes amid warnings that possible further sanctions against Russia over Ukraine might hurt the U.K. economy.

The specter of upheaval comes at a time when markets are calmer than at any point since the financial crisis, as an expanding economy and subdued inflation fuel an appetite for risk. Political instability topped the list of concerns in a Deloitte survey of chief financial officers released July 7.

“Now the economy is doing wonderfully, that leaves you with this great concern about political risk,” said Steven Bell, an economist at F&C Management in London. “It’s only a matter of time before this crystallizes in investors’ minds.”

Polls suggest the May election remains in the balance, with the Labour opposition leading the Conservatives by about 3 percentage points. Investors see risks, whichever party rules.

If the Conservatives win a majority -- the party has governed in a coalition with the pro-EU Liberal Democrats since 2010 -- Cameron has vowed to negotiate more favorable terms for Britain in the 28-nation bloc and put the results to voters in an in-or-out referendum by late 2017.

‘Real Risk’

Labour leader Ed Miliband has pledged to freeze energy prices for 20 months, increase corporation tax for big companies and reinstate a 50 percent top income-tax rate as he seeks to put the party on the side of ordinary voters and small firms.

“The real risk is that an economically mildly damaging set of policies turns into much wider intervention,” said Rob Wood, an economist at Berenberg Bank in London. “However, a Labour win would mean no Brexit referendum, at least on current policies.”

Similarly, doubts are growing over the future of Scotland, where nationalists seeking to break away from the U.K. are gaining ground less than two months before the Sept. 18 referendum.

Voters in favor of preserving the 307-year-old union saw their lead over the nationalists narrow to 9 percentage points over the past month and enough people are undecided to sway the result either way. According to Wood, a No vote too small to kill the independence question could drag on investment.

Volatility Seen

The uncertain outlook may just be starting to rattle investors, with sterling expected to experience more volatility in the coming months and investors demanding more to hold corporate bonds relative to risk-free government debt.

Three-month implied volatility in sterling versus the dollar -- a measure of expected price swings based on options prices -- was at 5.46 percent today. It declined to 4.96 percent on June 9, the lowest since June 2007. Morgan Stanley says the pound could drop as much as 10 percent on a trade-weighted basis if Scotland chooses to go it alone.

Sterling investment-grade non-financial bonds yield 120 basis points more than government debt, according to Bank of America Merrill Lynch index data. The spread fell to 114 basis points in June, the lowest since 2007.

“The risks related to series of events that will kick off with the Scottish referendum are being hugely underestimated,” said Philippe Gudin, chief European economist at Barclays Plc. “And the U.K.’s departure from the EU would completely change the country’s position relative to Europe and the rest of the world.”

Improving Economy

The quarterly Deloitte survey of 112 chief financial officers rated the election the riskiest event at 55 out of 100, followed by a possible EU referendum at 50. The Scottish referendum was rated 38.

Cameron needs to find votes to stay in power. A July 15-16 YouGov Plc poll had Labour leading the Conservatives by 36 percent to 33 percent, enough to give the party a majority of about 30 seats in the 650-member House of Commons, based on standard calculations. The Tories require at lead of about six points to win outright because Labour votes are concentrated in urban areas.

Cameron is counting on brightening economic prospects to lift a six-year squeeze on household incomes. Britain is set for its fastest growth since 2007 this year, employment is at a record and inflation is less than 2 percent. The pound reached its highest level against the dollar since 2008 on July 15.

‘No Going Back’

He’s also toughening his rhetoric toward the EU in attempt win back voters from the U.K. Independence Party, waging a vocal, if unsuccessful, campaign to keep Jean-Claude Juncker from heading the European Commission and giving his government a euro-skeptic tilt in a cabinet makeover last week.

A Survation poll carried out last month showed Britons wanting to exit an unreformed EU outnumbered those in favor of staying in by 47 percent to 39 percent.

“I think people should be more worried than they are about Brexit,” said Tim Bale, professor of politics at Queen Mary University in London. “It’s difficult to call as there are so many unknowns. These things have a horrible habit of going wrong. And once we leave, there’s no going back.”

Markets are in danger of underpricing the risk of an EU exit, according to Adam Posen, president of the Washington-based Peterson Institute for International Economics and a former Bank of England policy maker.

“It is very difficult for anyone to grasp something which is very bad but not disastrous or destabilizing,” he said. “The U.K. leaving the EU would be negative for all involved but not disastrous in narrow financial-default terms.”

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