By Matt Falloon
Few would bet against a big win for Britain's revived opposition Conservatives at the next election, but markets fear the worst case scenario for the investor could yet materialise — a hung parliament.
Political risk in Britain is back on the radar after a recent attempt to destabilise Labour Prime Minister Gordon Brown from within his own party knocked the pound lower.
A hung parliament — last seen in 1974 — or a tiny majority for the victor after an election which Brown must call by mid-2010 would send shivers through markets.
"Markets are hoping that come May or June, we enter a period of strong government," said Philip Shaw, chief economist at Investec. "Were that not to be the case, it's easy to envisage a run on sterling and gilts selling off."
Political analysts say the best the Labour government can hope for is to stop the Conservatives gaining a workable majority in an election which Brown must call by June 2010.
The best for Labour, however, would be the worst for markets looking for tough action on the ballooning public finances.
"Without either party getting a clear mandate in parliament, there would be a danger that those tough policies aren't carried through," said Investec's Shaw.
The Labour government has suffered regular rebellions within its own ranks as did its Conservative predecessor in the 1990s. A narrow majority would allow a small band of disaffected government parliamentarians to scupper or delay legislation.
Credit ratings agency Standard & Poor's has said Britain could lose its triple A rating over concerns about the debt burden. The International Monetary Fund warned Britain this week to get its books in order, saying the market's patience "will not last forever".
Investors are already uneasy about Labour's plans to deal with record public borrowing, forecast at 175 billion pounds — more than 12 percent of gross domestic product — this year.
The Conservatives haven't been very convincing either.
And in a hung parliament, Britain's third main party, the Liberal Democrats, could find themselves kingmakers eager to push their own fiscal agenda — an unknown for many investors.
NOT IMPOSSIBLE
Such an unsettling election outcome is not impossible, analysts say, despite a steady and strong opinion poll lead for the Conservatives and growing dissatisfaction with the 58-year-old Brown's Labour, in power since 1997.
"At the moment, if things carry on we will have a fairly big Conservative win, not a landslide. I don't envision a Labour win at all," said Julia Clark, head of political research at pollsters Ipsos MORI.
"But if the economy does recover and the Tories run into any kind of trouble, we could be looking at a hung parliament."
To scupper the Conservatives chances of a decent majority, Labour needs the economy to recover faster than anticipated and the electorate to lose some of its confidence in the Conservatives, led by 42-year-old Oxford graduate David Cameron.
The latest opinion polls give the Conservative around a 15-point lead over Labour — more than enough to destroy Labour's 63-seat majority and establish a stronghold.
But if the Conservative poll lead drops to five points that could indicate a hung parliament was in the offing, Clark said.
The Conservatives know they can't be complacent and, at some point, they must fill the policy gaps critics point to.
Labour business minister Peter Mandelson said this week the election was "open", labelling the Conservatives a party with no ideas that had garnered little more than cosmetic support.
The lack of policy is something that bothers markets too.
"Whilst the Conservatives have done well in the polls, they haven't been very explicit on policy," Investec's Shaw said.
"It may be they have to outline a number of policies that the electorate finds unattractive. Accordingly, it's not impossible that we see a smaller majority, a hung parliament or even perhaps a small Labour majority."
ECONOMIC RECOVERY
The other big unknown is the economy. Brown is expected to wait until the last minute before calling an election, in part to give the economy as much time as possible to recover.
That strategy could pay off.
Surveys suggest Britain is emerging from recession faster than predicted and faster any other big economy. Economists say the chances of a solid recovery are greater than a relapse.
The government has predicted a fall in output of 3.5 percent this year and then modest growth of 1.25 percent in 2010.
Any sign the economy is in better shape than those forecasts will give Brown a trump card as the election nears — evidence to argue Labour's costly fiscal stimulus has worked.
"If New Labour could start to do something that not only demonstrated there was a recovery but that New Labour was responsible for the recovery then that might change things a bit," said Bristol University politics professor and Labour expert Mark Wickham-Jones.
However, even if the economy rebounds, voters could feel recession aftershocks right up to election day, particularly in the form of politically damaging job losses.
"It's still going to feel pretty awful for a long while. Until GDP is back at potential, unemployment will still be rising — there are 100,000s of job losses to come," said Alan Clarke, UK economist at BNP Paribas.
"To the average person it's not going to feel like the recession is over, even if it is in technical terms."
