Markets are worrying about the wrong thing in the UK election

You may be surprised by what could end up mattering most on the potential implications for financial markets of the upcoming UK general election.

Yes, markets might react, at least initially, to what they currently perceive as different outcomes for economic policies and EU membership depending on who ends up governing and in what form. But a more lasting differentiator is likely to come from a less appreciated factor — that is, the various approaches towards a financial services industry that has yet to restore its credibility after the debacles of the global financial crisis.

At least superficially, the Conservative and Labour party manifestos propose different futures for economic management. Yet their ability to implement their paths is subject to considerable political and economic constraints.

With neither party set to emerge from the polls with an overwhelming victory, there is limited scope for radical policy shifts. At the same time, neither wishes to risk an economic recovery that is impressive on job creation but, judging from last week’s gross domestic product data, is yet to develop secure roots.

Rather than major changes to economic management, what is likely to follow in most post-election scenarios is just some tweaking of the current approach. This would include some easing of austerity policies and marginal structural measures to boost productivity and economic growth. Meanwhile, absent some extreme partnerships that would involve either the Scottish National party or the UK Independence party in a decisive role, the two main parties are also likely to end up with rather similar approaches to immigration and foreign policy — at least, alike enough for the financial markets.

The gap appears larger when it comes to the EU. As the Conservatives have promised to hold a referendum on staying in Europe if returned to Downing Street, a win for them would initially bring greater uncertainty into the marketplace. By undermining UK companies’ access to such a large market, an exit would weaken corporate profits. Equities would underperform while bond spreads would widen as markets price in higher volatility risk.

Yet, it is highly unlikely that such a referendum would lead to a UK exit. Most likely, a vote would take place after a re-elected prime minister David Cameron had secured concessions from his EU partners — not enough materially to alter the functioning of the single market, but sufficient to have the Tories join other parties in urging voters to opt for continued EU membership. In such circumstances, British voters are likely to choose staying in.

Indeed, the biggest potential difference, and the one with the greatest potential financial market impact, is elsewhere.

A Labour government would be likely to take a less lenient approach towards a financial services industry that has yet to overcome a huge trust deficit within society. It would be more open to tighter regulation, limits on pay and the pursuit of a series of high profile legal cases against offending companies. It would engage in a spirited debate with companies threatening to move their headquarters from the UK. It would also be less inclined than the Tories to fight off creeping European regulatory infringement on the operations and risk taking of financial institutions.

With all this leading to a further shrinkage of the financial sector, markets would price in higher risk premiums for both bonds and equities on account of lower future liquidity — that is, tighter constraints on broker-dealers assuming significant counter-cyclical risk as end investors wish to reposition themselves amid changes to fundamentals elsewhere. Such an adjustment could be quite pronounced given the extent to which markets, captivated by the illusion of liquidity, have grossly underpriced a risk factor that is subject to both secular and structural deterioration. It would then be more incumbent on the government to deliver on the measures needed meaningfully to boost growth and validate high financial asset prices, including productive infrastructure investment and tax reform. The alternative is asset prices that converge to the lower fundamentals, overshoot them and risk contaminating the general economy.

In regard to the upcoming election, financial markets have less to worry about than commonly thought on traditional economic and EU issues. What they should be doing instead is better guarding against the gross underpricing of liquidity risk, an already pronounced phenomenon that could prove an important differentiator when assessing the implications of the polls.

This post originally appeared on the Financial Times.

Mohamed El-Erian is chief economic adviser to Allianz and chair of President Obama’s Global Development Council