How to trade the UK election: 6 lessons from the past

We cut through the election "noise" and take a look back at some trends from elections past, the most likely outcomes and the implications for financial markets.

​​​​​​​​​​​​​​1. The known unknown

At the moment the only thing that investors can be certain of in the run-up to the 2015 UK general election is that the outcome is uncertain.

The last time an election was this close, in 1992, there was a late swing that dumbfounded expectations, indicating the futility of opinion polls. One online bookmaker is estimating a 70-80% chance that no party will gain an overall majority this election.

Such uncertainty poses a distinct threat to sterling in the days leading up to polling day, with GBPUSD weakness a distinct possibility in the event of a hung parliament or during coalition negotiations. That said, dov​​ish tones from the Federal Reserve about the first rate hike could move the pair in the other direction.

2. Hung parliament

The closest comparison for the 2015 election could be the 1974 election: no majority winner and failed coalition negotiations led to a second vote in October of the same year. There is every chance that for the first time in a generation we could experience two elections in the same year.

Only twice has the UK stock market fallen before and after an election since 1966. One of those was in 1974 when the FTSE All-Share index fell by 21% ahead of the second election vote that year.​

3. Coalition

Poll show three possible election outcomes:

• Labour-led coalition: HSBC believes the most likely two-party government could be Labour and the SNP, which given the recent Scottish referendum introduces a host of constitutional pressures and uncertainty.

Labour's tougher stance on UK banks could hurt stocks such as HSBC Holdings PLC, Barclays PLC and Royal Bank of Scotland Group PLC in this scenario. Utilities shares too – such as SSE PLC and Centrica PLC - may slide as Labour has pledged to enforce an energy price freeze until 2017.

• Conservative-led coalition: If the Conservatives are to form a coalition then they could be forced to partner with UKIP. In this case, a referendum on Europe has been promised and would likely have a destabilising effect at home and within the Eurozone.
• Minority government: Neither of those sound particularly palatable or harmonious, which mean Labour or the Conservatives trying to go it alone as a minority government.

In the short-term this could have a stabilising effect on markets as neither would have the remit or power to make much change, therefore the status-quo will remain.

Longer-term, however, sterling could devalue and the FTSE 250 - a good measure of confidence in Britain's businesses – might drop.

4. Volatility

Market volatility tends to increase in the 15 days before an election, and then increase further in the days afterwards, staying at a high level, according to the Stock Market Almanac.

Research also suggests that the rate of sterling vs euro has, on average, increased in volatility by 40% over the last seven General Elections". Volatility reached a record high in 2010 when coalition government was elected.

Remember how quickly UK markets became unsettled in the run-up to the Scottish referendum? Traders should prepare and implement hedging strategies in line with their portfolio objective.

5. Hedging bets

During previous election cycles we have witnessed FX volatility fall in the months leading up to the election date and rise immediately after the result is announced. However, uncertainty around a new coalition government could result in heightened volatility before the vote.

While GBP has regained some lost ground in recent days, there has been a big jump in the cost of hedging against a fall in sterling against USD. The cost of insuring against sterling volatility for the next month jumped to a three-year high and is already larger than it was in the run-up to the 2010 election.

6. Market movements

Barring a late collapse, the UK stock market will be at or near all-time highs when the general election begins. What can we expect from the FTSE All-Share during polling period?

Stock Market Almanac reported that, on average, markets across Europe[1] were abnormally strong in the 15 days prior to an election, and abnormally weak for 15 days after. It found election day to produce the strongest returns of the whole period, and weakest 13 days after the election.

Extreme swings and loud market 'noise' are likely to abound, suggesting that traders with conviction to a pre-determined trading plan will avoid the emotion-driven highs and lows fuelling the markets during election period.

[1] The study analysed data from 13 markets in Europe for the period 1990-2012.