The markets are putting too much money on the Tories

Sentiment in the markets ahead of the UK election is eerily similar to that before the referendum on European Union membership in June 2016. Complacency seems to have the upper hand, so if the election result is a surprise, expect a sharp readjustment.

The pound climbed to the highest level in seven months versus the US dollar, and rose to a 31-month high versus the euro, as the Conservatives seem sure to secure a majority in the December 12 election.

Sure, the pound is nowhere near where it was before the EU referendum – at the time, it traded at around €1.30 and $1.48, whereas currently it is around €1.19 and $1.31. But even so, it looks like too many traders are on the same side of the boat, and whenever that happens, the boat begins to tilt dangerously.

What about stock markets? After the EU referendum, the relationship between the pound and the FTSE 100 had been almost perfectly negatively correlated – as the pound depreciated, the FTSE 100 rose, because traders believed the weaker pound would benefit the companies that make up the index, which have many operations abroad.

However, news that the Conservatives had advanced in opinion polls ahead of the election pushed the FTSE 100 higher as well.

Data on capital inflows analysed by Bank of America Merrill Lynch showed record eight-week inflows into UK equities last week, with investors rushing back after having neglected the UK for so long.

UK equities 8-week rolling inflows

UK equities 8-week rolling inflows. Source: BofA Merrill Lynch Global Investment Strategy, EPFR Global

But with all these inflows tilting the boat dangerously to one side, the risk of its capsizing is increasing. While the polls do show the Tories ahead, it is hard to tell how the voters will react on election day, and it is not 100% sure that they will have a comfortable majority.

Presumably, the markets would like a Conservative victory because investors believe this would remove uncertainty about the UK leaving the EU. But far from removing it, an outright Tory victory in the election would actually make uncertainty worse.

Even if the Conservatives do get a comfortable majority, the fact that “getting Brexit done” is just a slogan, not a real world possibility, will hit markets before it hits politicians.

With new, more bellicose European Parliament and Commission members, the risk of the EU being intransigent in its dealings with the UK is higher.

This is not helped by the fact that the UK government does not seem to care about improving relations, and is frequently boasting about curtailing the rights of citizens of European countries it nevertheless calls “our friends and allies”.

Politicians in the EU will be keen to bring some easy victories back home to their own voters — and what would be easier than to demonstrate they can be tough on a member who is leaving the club after being treated as the club’s favourite for decades?

Just like before the EU referendum in 2016, investors are betting too much on one side. Whatever the result of this election, the hard work only starts afterwards. A positive outcome is far from guaranteed.