By Jeremy Gaunt, European Investment Correspondent
LONDON, Jan 20 (Reuters) - For a country faced with huge fiscal problems, a possible downgrade in its debt rating and an election where no clear winner may emerge, Britain is getting a relatively easy ride from overseas investors.
Britain's major financial market assets -- stocks, bonds and currency -- are each being supported by external factors that could be masking the danger of a broader reversal. The suspicion is that more caution may be warranted.
UK equities have been driven higher by the improving global economy, bonds held up by the Bank of England's huge buying programme and sterling by valuation and the distress of others.
But, on paper, Britain does not look like a country to be encouraging such relatively robust investment.
The recession and the government's need to bail out the banks took a heavy toll on Britain's public finances, with the deficit shooting up to a record 12.6 percent of GDP this financial year -- the worst of any major economy. ***********************************************************
Graph on fiscal gap vs euro zone's weakest members:
http://graphics.thomsonreuters.com/0110/UK_DFTEZ0110.gif
Rise in net borrowing:
http://graphics.thomsonreuters.com/0110/UK_PSNB0110.gif ***********************************************************
Ratings agency S&P warned last year that it could downgrade Britain's triple A credit rating if credible measures to reduce the deficit are not forthcoming after the election.
And the election -- to be held by June at the latest -- has an outside chance of producing no outright winner, leading to the kind of political stalemate that is not conducive to action.
"I thought it would be more difficult (for Britain)," said Benjamin Melman, head of allocation at Rothschild Financial Services in Paris.
SUPPORT FROM ABROAD
An underlying sign of Britain's trouble can seen in credit default swaps as measured by Markit. The cost of insuring five-year UK gilts is some 80 basis points, around 66 percent more than it was back in October and double what it is now for fellow G7 member France.
Even this, though, is significantly lower than it was a year ago when it peaked near 165 basis points.
Part of the reason is that the world's tentative recovery has helped Britain's economy stabilise. As Melman puts it: "If everything gets better, the UK looks less frightening."
But there are also specific factors at work. Much of Britain's stock market, particularly but not solely at the blue chip end, is made up of companies with big overseas interests.
The FTSE 100 index <.FTSE> is up 1.3 percent this year and 58 percent since its 2009 low, with the broad all-share UK index <.FTAS> performing similarly. This is not as good as the U.S. S&P 500 <.SPX>, but the FTSE did outperform many major bourses on the way down in 2008.
"Britain, equity-wise, is a gateway into the continent and the sector composition of the UK stock market does not reflect the UK economy," said Franz Wenzel, strategist at AXA Investment Managers in Paris.
This suggests Britain's stock markets could weather any fiscal- or election-crisis storm better than other assets.
But that would not necessarily be the case for sterling, which has also been strengthening lately on the back of concerns over the euro zone's stability and the desire in many quarters to diversify away from the dollar.
And there is little evidence that investors are being anything more than cautious at the moment. U.S. food giant Kraft's successful swoop for British confectioner Cadbury this week hardly suggests concerns about gross long-term overvaluation of the pound.
Twelve-month implied volatility for sterling against both dollar and euro is also relatively low, at 13 percent and 11 percent respectively, and at levels last seen before the full impact of the financial crisis hit.
"Put" options, the right to sell the pound, are only slightly more expensive than "calls", the right to buy, and that suggests that at worst a mild weakening is expected.
Sterling also fell sharply immediately after the first strike of the financial crisis in 2008, making it look cheap to a lot of people. It has been steady on a trade-weighted basis <=GBP> for most of the past year.
Thanos Papasavvas, head of currency management at Investec Asset Management says overseas clients are attracted by its value.
"If you compare the UK with the albeit small probability of euro destabilisation (from Greece's debt problems), the UK has nowhere near the risk," he said.
GILTING THE LILLY
If there is to be a storm over Britain's finances, it likely would be triggered by a combination of political uncertainty and stress in the gilt market.
The latter has been boosted by the Bank of England's quantitative easing programme, which is on track to buy almost a third of all gilts in circulation, some 198 billion pounds ($325.3 billion) worth.
However, this still did not stop 10-year UK yields
Is it enough? The BoE is now expected to stop its buying programme, particularly after higher-than-expected inflation figures on Tuesday. That takes a huge player out of the market just as the political situation becomes more uncertain with the formal launch of the election campaign.
A sharp sell off in gilts would spill over rapidly to sterling and probably hit stock sentiment too.
For the most part, investors currently appear persuaded that no matter which party wins, it will be forced to launch an era of budget austerity and that the devil is only in the details about how austere and when it starts.
But this is too nonchalant an approach for some. Royal Bank of Canada, for one, is warning about the prospect of a government with a small majority or none at all, with no clout to take the decisions it needs to.
"The possibility of a hung parliament and all the horrors that go with it is not fully priced in at the moment," said Russell Jones, global bond and currency analyst at RBC Capital Markets. (Additional reporting by Christina Fincher; editing by Patrick Graham)