LONDON (Reuters) - Investors in British assets may be headed for a year of uncertainty as the developed world's second fastest growing economy faces something more usually associated with emerging markets: political risk.
The outcome of a national election next May is unclear and the ruling Conservative party says if it is returned to office it will hold a referendum in 2017 on whether to leave the European Union -- a hugely disruptive prospect that has not yet been factored into the price of shares and bonds.
Prime Minister David Cameron's party is tipped to lose a second parliamentary seat to anti-EU party UKIP in a by-election later on Thursday, which will be seen by many as evidence the campaign to quit the EU is gaining momentum.
Investors from institutions running more than $6 trillion in assets attending a summit at Reuters offices in London said uncertainty over political outcomes next year is likely to hit Britain's currency and other assets, even if only temporarily.
Investors have already been forced to face the possibility of Britain undergoing huge constitutional change once this year when it suddenly looked like Scots might vote to leave the United Kingdom -- something markets had ignored until polls narrowed days before the referendum in September.
"You can draw parallels between what happened with the Scottish referendum and UK exit (from the EU)," said Themis Themistocleous of UBS Wealth Management.
"If suddenly the polls started swinging toward UK exit you (would) most probably see that reflected more in the market."
The threat of Britain leaving the EU should not be underestimated, said Saker Nusseibeh, head of Hermes Investment Management.
"We’re talking about redefining our ties with the partner with whom we do 50 percent of our trade. If that becomes a reality the market in the UK will go down. I think the (UK) treasury market will be hit because people will put more financial risk on the UK," Nusseibeh said.
George King of RBC Wealth Management drew a comparison with India where investors were cautious about putting money in before pivotal elections earlier this year.
"Ironically ... just as the political risk stream in emerging markets begins to ameliorate, we see it beginning to rise in the United Kingdom," King said.
"We are not trying to (predict the outcome of the election) ... all we are saying is that if the risk isn't priced in we should be aware of that and decide what to do."
While all the investors questioned by Reuters about political risk in Britain acknowledged that uncertainty would breed volatility for UK assets, many said they had not yet rearranged portfolios to fend off any impact.
Some said it was still too early to move as the elections are not until the middle of next year and markets are likely to continue to benefit from Britain's economic recovery for now.
"What is the timing of the first interest rate hike in the UK? Are there wage pressures emerging because of the good employment position? Those are the things driving our position now rather than at some point there might be a referendum," said Andrew Wilson of Goldman Sachs Asset Management.
"It's hard to take positions ahead of events like this when the outcome is so uncertain."
Others said that while there may be dramatic market impacts in the short term, investors should hold their nerve as British businesses were likely to muddle through, whatever the outcome of forthcoming polls.
"With the EU referendum, if it comes to that, there will be an awful lot of hot air and steam," said Anne Richards, Chief Investment Officer at Aberdeen Asset Management.
"You’ll see wild swings in the currency, probably see swings in the bond market ... Political risk creates uncertainty, creates turmoil, but businesses carry on."
Editing by Robin Pomeroy