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.
