The euphoria in U.K. financial markets over the surprisingly large Conservative victory in last Thursdays general election has quickly turned to caution over the potential political instability that may yet lie ahead.
Stocks were little changed on Monday after rising by more than 2 percent on Friday, with the FTSE 100 blue-chip index trading around 7,049. The pound, which jumped almost two cents against the dollar on Friday, firmed to $1.5517 from $1.544 at the end of last week.
Defying many predictions of a hung Parliament with no single party in control, Prime Minister David Cameron led his Conservatives to an outright majority with 331 seats in the 650-seat House of Commons. The party will now rule with a firm hand as its former coalition partners, the Liberal Democrats, imploded, while the opposition Labour Party captured only 232 seats, underperforming expectations.
Yet investors who look to the long term warn that one source of political instability lies ahead: a referendum on the U.K.s membership in the European Union. Cameron reiterated in his victory speech on Friday his promise to hold such a referendum. A vote for the so-called Brexit would foster the biggest change in the U.Ks relationship with the outside world in more than a generation and raise questions about British companies access to the EU single market.
Cameron will also have to contend with a yawning internal political gap, between Scotland and the rest of the U.K. The Scottish National Party (SNP), which ultimately wants independence for the region, swept 56 of Scotlands 59 seats in Parliament, an unprecedented result. The Conservatives, Labour and the Liberal Democrats were each reduced to just one seat in Scotland.
Cameron had repeatedly pledged that if reelected he would call a referendum by the end of 2017 on whether Britons want to leave the EU, after first negotiating with member states for the return of various powers to the U.K., including the right to limit immigration from other EU countries. Cameron has hinted that he might consider recommending a vote for Brexit in that referendum. But he hasnt said so explicitly or made clear exactly what he requires as acceptable concessions.
Investors warn that regardless of the result, the mere fact that a vote will take place could hit economic growth, and hence corporate earnings, as multinationals worry about whether they would be able to access the massive EU market from the U.K. without troublesome trade barriers.
For investors, a clear victory removes a tremendous amount of uncertainty in the near term over the ability of the government to govern and legislate, says Azad Zangana, senior European economist at £320 billion ($496 billion) asset manager Schroders in London. However, he adds, in time, the focus of investors will shift to the uncertainty that will come ahead of the proposed referendum on the U.K.s membership of the European Union, which could prompt some domestic and overseas investment to be delayed.
David Page, London-based senior economist at Frances 623 billion ($695 billion) AXA Investment Managers, thinks concern about the EU referendum could shave 1 percent off business investment, a key element in Britains economic recovery. Such a hit to growth could reduce corporate earnings and dampen equity markets, but the effect would be small compared with the likely market reaction to a vote for Brexit, says Page, who estimates that such a verdict could push stocks down by 10 percent and send sterling below $1.40.
Recent opinion polls show a small lead for staying in the EU, but skeptics say past polls show the volatility of opinion.
The risk of Brexit may be closer than many investors think, as some political observers caution that Cameron might feel pressured into calling a referendum before 2017. This demand was one of the central tenets of the UK Independence Party, whose recent rise in popularity pushed the Conservatives into their referendum promise. Although UKIP won only one seat in Parliament, the party captured 12.6 percent of the popular vote, trailing only the Conservatives and Labour.
David Cameron wont have missed the fact that UKIP suffered a disappointing election in terms of seats won, and the fact that he will have to manage the divisive impact of a dominant SNP north of the border, says Gregor MacIntosh, CIO of the Absolute Return Bond fund at Sfr49 billion ($53 billion) Lombard Odier Investment Managers in Geneva. This combination relieves some of the pressure on him to move ahead wholeheartedly with an early EU referendum.
Although Cameron has, in theory, no need to humor the fiercely Europhile SNP, he has signaled since his election victory that he wants to close the political rift that has opened between Scotland and the rest of the U.K. since last years Scottish referendum campaign, when the SNP unsuccessfully fought for independence.
Some investors warn, however, that the greatest pressure of all on Cameron to take a tough line on Europe may emanate from within his own party. Euroskeptics gave John Major, Conservative premier from 1990 to 1997, a rough ride by exploiting his wafer-thin majority (which eventually disappeared altogether) to demand concessions. Major famously called them bastards in an unguarded moment. Cameron may, in due course, rack his brain for a similarly colorful word.