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By Anirban Nag and Kit Rees
LONDON, Oct 4 (Reuters) - Sterling slid to its lowest in more than three decades on Tuesday on fears of a "hard Brexit" from the European Union and its single market that could hurt the economy, although the weaker pound sent UK stocks surging.
The pound has already lost 1.7 percent against the U.S. dollar since Prime Minister Theresa May said on Sunday the formal process to take Britain out of the EU will start by the end of March 2017. On Tuesday, she added the divorce from the EU will not be "plain sailing" and that there would be "bumps in the road".
Many economists and investors fear May's government will back a "hard Brexit" option where Britain quits the single market in favour of imposing controls on immigration.
That could hinder inward and outward trade and constrict the foreign investment needed to fund Britain's huge current account deficit, one of the biggest in the developed world.
Economic activity has held up better than many had expected since Britons voted in a June referendum to leave the EU, but many policymakers are anxious about the prospects for future investment. The Bank of England launched a big stimulus package in August and may ease policy again in coming months, which could drag the pound still lower.
"Most of the key (BoE) members have expressed a willingness to continue acting pre-emptively ... and an expectation that more easing is likely to be necessary," UBS strategist John Wraith said.
"Additional stimulus would likely drive further sterling weakness," he said, reiterating the bank's forecast for $1.20 per pound and parity with the euro by end-2017.
The pound fell to $1.2735, its weakest since mid-1985. Earlier, sterling also hit a three-year low of 87.65 pence per euro and a 6-1/2 year low on a trade-weighted basis.
The nervousness in the spot market led to a rise in the cost of hedging against sharp swings in the currency in the next three to six months. The cost of hedging sterling exposure against the dollar for six months -- which includes March, when May says Brexit will begin -- was at 10.60 percent, the same as the nine-month option. Typically a nine-month currency option is dearer than a six-month one.
In contrast to the gloom and doom in the currency market, investors in British stocks were in a far more cheerful mood, highlighting a divergence in sentiment towards UK assets.
With a cheaper currency promising to bolster earnings and enhance competitiveness, Britain's FTSE 100 index rose above the 7,000-point level for the first time since mid-2015. The blue-chip index has risen more than 11 percent since its pre-Brexit level and is within striking distance of its historic high of 7,122.74.
Even more heartening for investors has been the rise in the domestically exposed FTSE 250 index of mid-sized British firms, which struck a record high and has gained around 24 percent since the lows struck just after the referendum result.
The mid-caps have benefited from recent upbeat data and surveys of British households and businesses that have led many forecasters to drop predictions the economy will slip into recession this year. JPMorgan, for example, doubled its third-quarter GDP forecast to an annualised 2 percent last week.
"Given the fact that we've not seen a significant negative impact on the economy as of yet, it's not surprising to see some of those domestic stocks recover from their lows," said Neil Veitch, manager at the SVM UK Opportunities Fund.
"I think what is much more difficult to ascertain is just how the UK economy holds up while these negotiations are ongoing and what comes out of those negotiations, because it's not going to be a terribly simple process."
Analysts and fund managers like those at Franklin Templeton also cited the prospect of more acquisitions as foreign buyers take advantage of a cheaper currency to scoop up UK companies.
"There's certainly a perception that, as you go down the market cap range, the potential list for takeover targets gets a bit longer," said Ian Williams, economist and strategist at Peel Hunt. "And, of course, for foreign investors who are looking at sterling-denominated assets, they are continuing to get a bit cheaper." (Writing by Anirban Nag; Editing by Ralph Boulton)