The British and continental European markets appear to have factored in a hung parliament in Thursday's United Kingdom elections. Investors are saying that they have more to worry about than the election's probable inconclusive outcome.
Instead, the dominant market story was the rout in the European sovereign bond market. The selloff in bonds, driving up yields, began in earnest at the start of the week and continued on Thursday as British voters went to the polls. The yield on benchmark 10-year German bonds rose by more than 20 basis points, an unusually strong move, taking the yield to 0.80 per cent (A basis point is 1/100th of a percentage point.)
But the relatively benign market reaction to the British election could change Friday, if either the Labour or Conservative parties score an upset. If Labour forms the next government, it promises to tax bank bonuses, boost the top tax rate and impose a mansion tax on luxury homes. It would also freeze energy prices and cap the profits of the suppliers to the National Health Service.
While the Conservatives have pledged no tax increases, they have vowed another round of austerity that could drastically shrink the size of the state (Labour wants austerity too, but a less aggressive form). The Conservatives have also vowed to hold a referendum on Britain's membership in the European Union. By and large, British companies, especially the biggest ones, oppose a referendum. They fear that Britain's exit from the EU – dubbed "Brexit" – would jeopardize their open, tariff-free access to the world's biggest market.
The Conservatives, under Prime Minister David Cameron, would hold the referendum in 2017. In an interview in March, Sir Martin Sorrell, CEO of WPP, the world's biggest advertising agency and one of Britain's top employers, said that if the Conservatives do win, they would be wise to hold the referendum next year instead of 2017. "Two years of uncertainty is too much," he said.
Labour, led by Ed Miliband, and the Scottish National Party (SNP), which is on course to win most of the seats in Scotland at Labour's expense, oppose a referendum. The markets could prove highly volatile down the road, if Scotland, under the SNP, holds another referendum on independence (it lost the referendum held in September). If the referendum were won, the breakup of the U.K. would surely rattle the markets and send many businesses in Scotland fleeing to England.
In London, the FTSE-100 index was down by 0.60 per cent while the pound lost 0.7 per cent against the dollar. Oil prices, which have surged 50 per cent since their January low of $45 (U.S.) a barrel, lost slightly more than 2 per cent. The sharp and quick rise in oil prices is raising fears of a return to inflation, one of the factors behind the bond selloff.
A flurry of new polls put Labour and the Conservatives in a dead heat within one or two points of each other – too close to call.
In a note, Nicholas Spiro, managing director of Spiro Sovereign Strategy in London, said that markets are not underpricing U.K. election risk. He said that Britain will not lose its status as a safe haven even if the outcome of the election is a hung parliament, and that investors are more concerned at the moment about bond volatility and Greece's potential exit from the euro zone.
He called Brexit the most significant post-election risk, but noted that "there may be domestic and external pieces that need to fall into place in order for a referendum to be held and, more importantly, for voters to vote for Britain's withdrawal from the EU … and it's not even clear that a referendum will be held."
Eric Reguly