LONDON (Reuters) - Sterling at a seven-week peak against a basket of currencies <=GBP> and UK stocks (FTSE) near record highs are challenging a widely held view that uncertainty surrounding Britain's general election will unsettle markets.
With just eight days to go, polls show the ruling Conservatives and the main opposition Labour Party neck-and-neck while support for Scotland's nationalist party has surged, making a hung parliament the most likely outcome.
Investors say the market impact of the May 7 vote will only be clear once a new government is formed -- probably the second coalition administration in a row for Britain, where one-party government has been the norm.
Investors worry that a weak administration would struggle to deal with Britain's big fiscal and current account deficits, and are concerned about a Conservative promise to hold a referendum on Britain's membership of the European Union.
Here is what some major banks say will be the market impact of the main potential election outcomes:
1) Conservative-led government, either alone or in coalition with the centre-left Liberal Democrats. The two parties formed Britain's first coalition government in decades after the last election in 2010.
GOLDMAN SACHS: Likely to be perceived as the most "market-friendly" outcome as it would be the closest to the status quo. However, the Conservatives' commitment to hold a referendum on EU membership by 2017 and the increased "Brexit" risk would likely be negative for UK assets.
MORGAN STANLEY: Gilts would rally. Sterling would drop due to EU referendum uncertainty, which would also dampen growth and see UK stock valuations trade at a discount relative to other countries.
UBS WEALTH MANAGEMENT: Sterling likely to decline to reflect the risk of uncertainty due to minority rule. Brexit fears would weigh on the currency. Gilts likely to rally because of lower issuance and while historical precedent suggests a favourable reaction in stocks, Brexit concerns are likely to be a drag.
BARCLAYS: Unstable government to drag on sterling and domestic UK stocks. EU referendum prospect will also be a significant negative for sterling, gilts, and UK banks and UK stocks with EU exposure.
2) Labour-led coalition with the Liberal Democrats.
GOLDMAN SACHS: Financial markets would likely respond more favourably to a Labour/Liberal Democrat coalition than to a minority Labour government supported by the Scottish National Party.
MORGAN STANLEY: A positive for sterling as it removes the two major risk factors -- an EU referendum and a non-traditional party holding the balance of power. Likely to result in a small relief rally for gilts after initial discomfort. For stocks, it could mark a step towards less business-friendly and more interventionist policies which could drag on corporate profitability and shareholder returns in the long term.
UBS WEALTH MANAGEMENT: Sterling could drop to reflect concerns about overall fiscal credibility. Gilt issuance could increase if the deficit reduction path is not adhered to, weighing on bonds. For stocks, historical precedence suggests a negative short-term reaction, especially if Labour successfully pursues its proposal to increase taxes and regulation on banks, tobacco and utilities.
BARCLAYS: Labour's campaign has suggested a fiscal consolidation path through a combination of spending cuts and tax rises. Increased taxes on capital tend to weigh on the currency. In stocks, utilities, banks, energy and insurance sectors could be at risk from increased regulation.
3) Labour-led government, with support from the Scottish National Party.
GOLDMAN SACHS: Concerns are likely to emerge that reliance on the SNP would pull the Labour government away from the centre and to the left of the political spectrum, as well as raising the spectre of policies favouring Scotland at the expense of the UK as a whole.
MORGAN STANLEY: The prospect of another Scottish referendum would weigh on sterling. It would also lead to a sell-off in gilts as investors are uncertain how anti-austerity and interventionist the government would be. It would also be negative for stocks.
UBS WEALTH MANAGEMENT: A perception of looser fiscal policy could be countered by a steeper path of interest rate rises, which could offer some support to the currency. Such an outcome could be negative for the front-end of the gilts curve while stocks are likely to be hit.
BARCLAYS: The SNP opposes austerity, while greater devolution to Scotland and other regions is likely to be negative for sterling. Stocks whose companies are headquartered in Scotland are most at risk.
4) No clear outcome, followed by a new election
GOLDMAN SACHS: The lack of clarity surrounding such an impasse would likely be damaging for UK growth and assets.
MORGAN STANLEY: This outcome could see the sharpest downturn in share prices as investor fear wrangling and the potential for another election. Gilts would rally as this outcome would be much more positive than lengthy coalition negotiations that would make investors more nervous.
BARCLAYS: Given the significant chance of an unstable government or even a snap election, there is a potential for a spike in currency market volatility