The end of the UK’s haven status

The outcome of Thursday’s Scottish referendum is officially “too close to call”, since the difference between ‘Yes’ and ‘No’ has been inside the margin of error of almost all the polls published since the sudden swing towards independence last weekend.

But markets are priced for near certainty of the status quo winning, with sterling stronger than a month ago against the euro, yen, Swiss franc and every other major currency save the dollar-and up 3% even against the dollar compared with a year ago.

In the very short-term this market positioning probably makes sense.

Despite the closeness of all the latest polls, only one of which shows the No vote ahead by more than the standard plus-minus 3% margin, the odds strongly favour the status quo because the results of so many separate polls are so close.

Now for the bad news for investors in sterling and other assets whose value is tied to the UK’s ‘haven’ status. Even if Thursday’s vote averts a breakup of the United Kingdom, the relief rally is likely to be very brief and very small. Within hours of the referendum result being declared on Friday morning, market interest will shift from the fate of Scotland to the fate of Britain as a whole-and investors may be quite shocked by looming problems as they re-focus their attention on British politics in the eight months remaining until the general election in May 2015.

LEADERSHIP UNDERMINED

Firstly, David Cameron’s leadership position has probably been irreparably undermined. Even if Scotland votes ‘No’ on Thursday, Cameron has suffered substantial and probably irreversible political damage because of the near-death experience that British politicians, media commentators and public opinion suffered last week. Unless the polls turn out to be completely wrong and unionists win by an overwhelming margin, voters and increasingly febrile Conservative MPs will blame Cameron for what, with hindsight, were misjudgements in the way the referendum was run: the date of the referendum, which gave nationalists the best possible opportunity to organise; the phrasing of the question, which needlessly forced the unionists into a negative campaign; the bizarre decision to lower the voting age to 16; the absence of a supermajority of 60%; and, Cameron’s insistence that voters should be confronted with a binary decision between total independence and preserving the status quo instead of being offered a middle-way alternative of “maximal devolution”, which the nationalists proposed as a compromise three years ago.

Secondly, the unprecedented fiscal devolution that Cameron felt forced to offer Scotland last week will confront him with huge political problems in the rest of Britain. If Scotland is granted the right to set its own income tax and spending levels, the UK government will lose effective control of Scotland’s budget deficits and that will surely inflame opposition in the rest of Britain to the fiscal austerity policies of Cameron’s coalition.

FISCAL LEGISLATION

Moreover, English politicians are already arguing (quite reasonably) that if Scotland can determine its own fiscal policies, Scottish MPs should be deprived of the right to vote on UK fiscal legislation from which Scottish voters will be exempt. These demands raise the prospect of another constitutional upheaval for which Cameron seems unprepared, adding to the impression of his government’s complacency and incompetence.

Thirdly, if the Tories do win the 2015 general election, an EU referendum will loom in 2017 and the results now appear much more uncertain. Not only will Cameron’s weakness allow his party to become more far more Eurosceptic, but the Scottish experience has shown that voters may be willing to defy a united front of the main political parties, the media and the business community-and daringly overturn the status quo.

Finally, as international investors look more closely at the British political landscape they will notice that the alternative to a Conservative victory next May would be the election of a Labour Party or Labour-Liberal government committed to probably the most radical shift in policies on taxes, public spending, financial regulation, labour markets and business intervention that Britain has seen since the 1970s. They will also notice that voting intentions, as of today, strongly favour a Labour victory – and that the strong economic recovery still shows no sign of shifting public opinion in favour of the Cameron government.

Of course, polls today do not reveal how people will vote eight months from now. But the feature of the political landscape that investors should find most troubling-and frankly surprising-is how little movement there has been from Labour to the Tories in the past 12 months, despite the unexpected strength of the British economic recovery.

For the Tories to win a majority in May they will need an eight or nine point advantage over Labour and to lead another coalition government by remaining the largest party in parliament they will need about five points. So far, there has been no sign of any such movement in public opinion. Most investors and many analysts (including me) expected an upsurge of support for the Tories as the election approached, but the events in Scotland have made this shift of opinion towards the Tories much less likely.

In sum, the UK is likely to survive the referendum. But investors should not expect a big relief rally. After the Scottish vote, the whole of Britain will face a political choice between the devil and the deep blue sea: either a tax-raising Labour government or a Conservative-led government dominated by Euro-phobia. Neither seems an attractive prospect for investors in sterling and other politicallysensitive assets in Britain.