COLUMN-Markets sleepwalk as British election looms: James Saft

By James Saft

March 31 Wildly unpredictable and potentially having a huge impact on future growth, Britain's upcoming general election is the kind of event financial markets should hate.

And yet, investors are largely calm about the outcome, testament to just how muted adrenal response can be in an age of faith in central banks.

Prime Minister David Cameron met the Queen on Monday to tell her Parliament was dissolved, setting the clock for a May 7 election. Not only is it unclear whether Labour or the Conservatives will win the most seats, polls being highly mixed, it is unlikely that either will win enough support to form a government on its own, making coalition or minority government strong possibilities. Fringe parties, like the anti-EU UK Independence Party may play an outsize role in forming, or scuppering, any coalition.

What's more, a 2011 law establishing fixed five-year terms for parliaments will make it difficult for a weak victor or coalition to call a new election in hopes of a more clear-cut result.

Cameron has pledged a referendum on British membership in the EU by the end of 2017 should the Conservatives win, but even Labour, strong supporters of staying in, might ultimately have to put the issue to a vote. A vote to leave the EU might trigger yet another vote over Scottish independence, something defeated last year.

In short, it is very difficult right now to know the future shape of Britain, how and by whom it will be governed, as well as the treaties, laws and regulations to which it will be subject.

Given all this, markets have been remarkably relaxed.

Sterling has fallen against the dollar, having one of its worst months in the last couple of years, but while volatility is up, this is within a low-volatility environment.

The benchmark FTSE 100 is up about 5 percent so far this year and stands just off all-time highs, albeit a high set in December 1999. Volatility on the FTSE 100 has been trending generally lower for the past three months.

To be sure, investors, as a group, are fickle creatures and there is every chance that they wake up one fine morning between now and May 7 and decide to panic, if only a bit. There is sure to be volatility in reaction to evolving poll data. Signs of a Conservative majority would be especially difficult for sterling, which then faces so-called Brexit risk via the promised referendum.

Individual equity sectors such as banking could be hard hit too, not to mention companies based in Scotland.

The strength of British institutions is reassuring, of course, but still this is a remarkable set of uncertainties driving a remarkably quiet market response.

Should Britain leave the EU it will be highly damaging to its economy. Not only would London's role as the capital market entrepôt of Europe face a threat, but EU countries are the most important market and trade partner for Britain.

Lower trade with the EU would knock British economic output down by between 1.1 and 3.1 percentage points, according to a study by the London School of Economics. Foreign investment would surely drop and new roadblocks to skilled immigration might appear.

And Britain doesn't have to leave the EU to lessen its influence over the direction and outcome of the European project. A referendum might do that even if it ended in a vote to stay.

The quiet reaction in Britain makes an interesting parallel to how markets are interpreting events in Greece. While Athens risks running out of cash in April, and the chances of a euro exit, by plan or by accident, must be rising, outside of the Greek securities which could be redenominated into new drachma, the market impact has been subdued.

That may well be because the effect of the European Central Bank's new quantitative easing program is papering over the underlying impact of Greek risks. That's possible if true, and possibly even desirable, but not necessarily permanent.

For a long time, in the so-called great economic moderation ending in 2008, investors thought we were living in permanently calm times. Markets erupted when they realized this was not true, but the effective actions, mostly of central banks, have taught investors in the years since that it pays to bet the 'grown-ups' will sort things out in a way which protects the economy and investors.

Local problems and instability have been less powerful than the combined efforts of multilateral ones and especially central banks.

Britain's lesson may soon be that politics will one day matter again. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)