As polls point to close election result, UK markets bracing for uncertainty

British financial markets could be headed for choppy waters after Thursday's general election, as investors face the prospect of it taking days — even weeks — to form a new government.

In the past five weeks, investors have held off making big bets on an election that looks to be the most uncertain in decades — the pound has edged above $1.50 and stocks have risen modestly. More important for investors have been global factors like the pace of U.S. interest rate increases or whether Greece defaults.

Now, with the election looming Thursday, investors can no longer afford to turn a blind eye.

Opinion polls suggest the Labour Party or the Conservative Party will not win a majority to the House of Commons, meaning as many as ten different varieties of government are possible.

That could lead to horse trading and pork barrel politics, fueling uncertainty over Britain's economic path, particularly over the public finances, its future in the European Union and a possible second independence referendum in Scotland.

"Markets may be in for a very bumpy ride in the immediate aftermath," said Oliver Harvey, a strategist at Deutsche Bank.

Though it is common in continental Europe for it to take weeks to form a government, it is unheard of in postwar Britain. There's no mechanism for a U.S.-style ten-week transition here.

In 2010, when the general election produced no majority winner, the uncertainty only lasted for five days — three market days — until the Conservatives and the Liberal Democrats agreed to form Britain's first coalition since Winston Churchill's national government in World War II.

At the time, the mandarins of Whitehall and the governor of the Bank of England urged a swift resolution because of market concerns over the parlous state of Britain's public finances in the wake of an acute banking crisis and Greece's recent bailout.

The markets soon breathed a sigh of relief, especially as the new government made reducing the deficit its primary objective. The pound rallied and the interest rate on British government bonds eased.

How markets react if any negotiations drag on longer this time is the question many investors are grappling with.

Jane Foley, senior foreign exchange strategist at Rabobank International, thinks this election has "the capacity to create more uncertainty than the last," partly because the Conservative Party has made a referendum on Britain's membership of the European Union by 2017 a cornerstone of its manifesto.

"The risk that Britain could leave the EU has the potential to worry international investors more than the general election," said Foley. "Given also the unknowns regarding the composition and coherence of the new government, on almost all outcomes the uncertainties for investors could rise post-election."

The experience last year of the referendum on Scotland's independence showcased the extent to which British markets — whether it be the pound, bonds or stocks — are vulnerable to political uncertainty. When an opinion poll a couple of weeks ahead of the Sept. 18 vote indicated that a small majority of Scots backed independence from the rest of the country, the pound suffered a notable fall. Eventually, the pro-union side won over 55 percent of the vote.

Scotland is likely to feature heavily in the post-election landscape, as most opinion polls show the Scottish National Party set for unprecedented gains, mainly at the election at the expense of the Labour Party. The SNP's popularity is the main reason why Labour is not expected to win a majority.

There is a market concern that a big presence by the SNP in the next parliament will prompt more devolution of powers to Scotland and make another independence referendum in coming years more likely. Though the SNP's leader, Nicola Sturgeon, has insisted that an overwhelming SNP victory does not provide a mandate for a fresh referendum, she has said her backing of a minority government will come with strings attached, notably on government spending.

Bill O'Neill, head of UBS Wealth Management's U.K. investment office, thinks the prospect of a second Scottish referendum will "simmer" if the SNP does as well as polls suggest, even though he doubts it will be an immediate concern for markets.

"From the perspective of the markets, devolution will grow in importance through the life of the next parliament irrespective of whether Labour or the Conservatives hold power," he said.