The British pound has been riding high. An election surprise could send it crashing

Investors are betting that Prime Minister Boris Johnson will sweep to victory in Thursday’s election. If he doesn’t, the pound and UK stocks are poised to plunge.

The pound has strengthened about 2% since the general election was called in late October, and on Wednesday was trading near a seven-month high around $1.31, and way above a low of $1.20 hit in August. The FTSE 250 index of midsize British companies has gained roughly 3%.

Traders are counting on Johnson, who has held his lead in the polls against Labour leader Jeremy Corbyn, to score a majority in parliament on December 12. This would allow the Conservative leader to take the country out of the European Union by January 31 — removing some of the Brexit uncertainty that has hung over businesses and markets for more than three years.

“It means more clarity about what government intends to do,” said Jordan Rochester, a currency strategist at Nomura.

Should Johnson win, UK markets are expected to hold onto recent gains, though they may not rally much beyond that, particularly if the margin of victory is slim and once traders begin to focus on the longer-term risks of his Brexit plan.

An unexpectedly strong showing from Labour, meanwhile, could result in a shock. The odds of the opposition party winning an outright majority look small. But recent polling suggests there’s still the chance of a hung parliament, which would open the door to Labour forming a minority government with the support of a smaller party.

“The biggest surprise would be a Labour-led coalition, which would not only hurt the pound, but also hit [UK government bonds] and especially equities,” Andrew Wishart, UK economist at Capital Economics, wrote Tuesday in a research note.

Capital Economics predicts that the pound would fall sharply, possibly to $1.20. Investors would also dump energy and financial stocks, according to Rochester, who sees the pound initially diving 3% on news of a Labour-led minority government.

That’s because of Labour’s policies on business and the economy. Corbyn has promised to raise corporate taxes, empower unions and award 10% of companies’ shares to their workers. He would also nationalize major utilities, including water, energy infrastructure, railways and broadband, and borrow heavily for investment in long-term projects such as green infrastructure.

In the eyes of the business community, near-term concerns about those plans outweigh the party’s well-received pledge to give UK citizens a chance to call off Brexit — which is seen as economically damaging in any form.

The structural changes caused by Johnson’s Brexit deal are expected to diminish the country’s economic prospects once an immediate boost from the removal of political uncertainty fades. And Johnson has given himself just one year to negotiate a detailed agreement on future terms of the United Kingdom’s relationship with the European Union. If he can’t get a deal in time, Britain would face significant new trade barriers with its largest export market.

Labour, on the other hand, has pledged to boost public spending to levels not seen in a generation. That could juice the UK economy after a period of low business investment.

The party also wants to strike a new exit deal with the European Union that would maintain a closer relationship with the bloc than proposed by the Conservatives. Labour would then put that agreement up for a public vote while also giving voters the option of stopping Brexit altogether.

“It’s short-term gain, long-term pain if the Conservatives win,” Rochester said. “For Labour, it’s short-term pain, potential long-term gain.”

The haziest scenario for markets would be a parliament in which the Conservatives have only a slim majority, boosting the negotiating power of hardliners, or need to turn to another party for support, jeopardizing Johnson’s existing Brexit deal.

“[A] hung parliament creates uncertainty and investors don’t want to take on risk,” said Stephanie Kelly, senior political economist at Aberdeen Standard Investments.

For markets, anything other than a clear majority for the Conservatives would come as a surprise. A harsh reaction looks likely in that case.

— Anneken Tappe contributed reporting.