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Unpredictable U.K. Election Leaves Investors Wary

As the May 7 vote approaches, a minority government might be the best bet for avoiding Britain’s exit from the EU.

If Prime Minister David Cameron’s Conservative Party wins a clear victory in the U.K. general election on May 7, the country within a few years could undergo its most momentous change since the end of the British Empire more than a generation ago: withdrawal from the European Union. For this reason, the outcome of the election is more important than usual — and much harder to predict.

If he remains prime minister, Cameron has pledged that by the end of 2017 he will call a referendum on whether Britons want to leave the EU, after first negotiating with member states for return of various much-desired powers to the U.K., including the right to limit immigration from other EU countries. If he doesn’t get what he wants — and most Europe watchers think he won’t, given German Chancellor Angela Merkel’s opposition to immigration curbs — analysts believe chances are high Britain will vote for an exit.

“I think the market is being incredibly complacent about this,” says Tom Elliott, London-based international investment strategist at deVere Group, a Zurich-headquartered financial consulting firm with $10 billion under advisement and management. “If we leave, the EU’s main countries will make it very unpleasant for us.”

Elliott predicts the EU would impose tariffs on goods made in Britain, and that Germany and France would use European legislation to grab international financial business from London. This would hurt the economy and British corporations by hitting investment, he says; businesses in particular want access to European markets.

Looking further ahead, Elliott sees Europhile Scots seceding from the U.K. after a second independence referendum (last year Scotland narrowly rejected independence), with Wales and Northern Ireland possibly following suit. The result, he warns, would be a nation isolated from Europe, which shuts out overseas workers, despite their contributions to economic growth and corporate earnings. “What will be left will be a strange little nasty country that doesn’t like foreigners and doesn’t like the modern world,” he says.

Other analysts aren’t quite so apocalyptic about the consequences of a U.K. exit from Europe, but they do believe financial markets will react quickly if the Conservatives perform well enough to form a powerful government. David Page, London-based senior economist with France’s €623 billion ($659 billion) AXA Investment Managers, sees the British pound falling to as low as $1.40 right after the vote, compared with about $1.50 as of early March, with the FTSE 100 index dropping between 5 and 10 percent.

But how likely are the Conservatives to win?

That depends on what is meant by winning. Until early March opinion polls suggested that the Labour Party, under leader Ed Miliband, would take the biggest share of the 650 seats in the House of Commons, the U.K. Parliament’s dominant chamber. This was largely because the Conservatives’ prospects have been weighed down by the anti-EU U.K. Independence Party, which stunned the political world by placing first in last year’s U.K. elections for the European Parliament.

However, the Conservatives have recently inched ahead of Labour in some surveys. Voter gratitude for a recovery in household incomes may help them further: The London-based Institute for Fiscal Studies recently announced that this year living standards will finally return to where they were before the Great Recession of 2008–’09.

Still, opinion polls rule out an absolute majority for the Conservatives or any other party. Most pundits expect that whatever party wins the most seats will have to form a coalition government — similar to the current Conservative–Liberal Democrat alliance — or a minority administration. In this case, the biggest party would limp along in a weak government, perhaps with allies but without the majority of seats.

AXA IM’s Page notes that even if the Conservatives do win the most seats, the mathematics of a coalition-led or minority government could make it tough for the party to secure parliamentary approval for an EU referendum. He estimates that even if they were part of the government, many Europhile Liberal Democrats, and possibly some rebel Conservatives, would reject the referendum bill.

So would the Scottish nationalists. Following the resurgence in support since the “no” vote last year, which raised the Scottish National Party’s profile, they’re now expected to win the bulk of Scotland’s 59 seats in Parliament — possibly enough to give them an effective veto on any major U.K. policies the party doesn’t like.

Regardless of which party performs best, the political gridlock that may take hold in Britain after the election worries many investors. “Markets abhor uncertainty,” says Bill O’Neill, head of the U.K. investment office at $2 trillion UBS Wealth Management in London. “The key thing for them is to see a functioning government with a coherent program in place after the normal vicissitudes of building a coalition.”

Page puts forward a counterintuitive but intriguing point of view: A bit of gridlock may not be a bad thing. A weak Conservative-led government wouldn’t be able to put the U.K. on the road out of the EU, he reckons. A weak Labour-led government would find it harder to pass measures harmful to corporate earnings, such as an increase in the minimum wage, which would hit the retail sector.

“In some ways a minority government, be it Conservative- or Labour-led, might actually be the most market-friendly outcome, because it will prevent a move to the political extremes,” Page says.

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