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UK political risk: The next market storm?

Houses of Parliament in London, England.
Terry Vine | The Image Bank | Getty Images

The U.K. is facing its most uncertain political future for decades – some argue centuries.

With just over six months until the general election on May 7, predicting who will hold the balance of power is becoming increasingly difficult – and worrying – for investors. The election will affect more than just U.K. voters, it'll also decide whether the country stays part of the the European Union (EU).

"This is the first time in a couple of centuries we have had so many possible outcomes," James Bateman, head of portfolio management at Fidelity, told CNBC, as he warned of more volatility in the lead-up to election.

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Trouble for every political party?

The latest poll, by YouGov for The Sun newspaper, suggests left-wing Labour are leading with a 34 percent share of the vote, while the ruling Conservative Party are at 31 percent. The more interesting news is further down the rankings, where anti-EU U.K. Independence Party (UKIP) are showing a 17 percent rating, outstripping the Liberal Democrats (LibDems), currently the junior coalition party in government, with 6 percent. The LibDems have also fallen behind the Green Party -- which like UKIP has just one elected member of parliament -- suggesting that the position as the third party in the country is in danger of wipeout.

The U.K.'s first-past-the-post system means that, even if this share of the vote holds up, it may not translate into an equivalent share of the number of seats in Parliament come May. Still, there will be nervousness around the possible future outcomes in the markets until then, and possibly even well after the hangovers from the morning of May 8 had faded.

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Who's going to lead the country?

While an overall Labour majority may seem, on one hand, potentially a serious negative for businesses given the party's lack of courting of the City, at least it would mean a government which was able to make decisions quickly, and which is likely to stay in power for the full five-year term.

The most worrying combination for those who want the U.K. to stay in the EU would be a Conservative/UKIP coalition – which would mean a referendum on its EU membership even earlier than the 2017 date slated if the Conservatives win an overall majority in 2015.

"Any government which has to rely on UKIP votes is going to find itself in a precarious situation on Europe," Bateman warned.

Nigel Farage, leader of UKIP, speaks during a press conference in London after his party's first win in a national election.
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A Conservative/LibDem coalition, while it might offer continuity, would also be viewed as weaker and more prone to disagreements than the current administration. Its majority would likely be smaller, as both parties are forecast to lose seats in May. And its politicians are diametrically opposed on key issues like how to deal with the EU, making the coalition's survival for five years questionable.

A Labour/LibDem coalition might look a more natural alliance to some on the left-wing of the LibDems, but there may be issues in personality, with polls of LibDem members suggesting that Labour leader Ed Miliband's perceived unpopularity among voters may be a barrier to a coalition.

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Why does it matter to markets?

For starters, after the credit crisis bailout, U.K. politics are intrinsically tied up with the fate of two of the country's biggest banks, Lloyds and RBS. And sterling's decline against the dollar has tracked concerns about U.K. politics in recent months (particularly around the Scottish independence referendum).

The outcome of this election is possibly most important for the U.K.'s future relationship with the EU. Like the Scottish referendum, this is one of those risks which was ignored until it caused panic in the markets – but could be a substantial negative for U.K. exports and investment if it happened.

"There's increasing political risk, and it's more to do with the EU now," Steven Saywell, global head of currency strategy at BNP Paribas, told CNBC.

"Even if it doesn't leave, that uncertainty will cause a lot of investors to be nervous."

- By CNBC's Catherine Boyle