For investors in British markets, it is now all about the politics.
Britain’s June vote to leave the European Union was a shock, but investors responded in fairly traditional ways: They sold the pound and bought government bonds, reflecting an expectation of lower interest rates to offset an economic hit. They bought stocks of British multinationals, whose foreign earnings suddenly look better when converted into weaker sterling figures.
But not for the past two weeks.
Since an Oct. 2 speech from Prime Minister Theresa May, traditional ways of valuing British markets have broken down, and investors have turned their focus squarely to politics. Mrs. May’s speech set out a forceful position on how Brexit would go: Immigration controls, she said, were a higher priority than access to the EU’s common market.
The result has been a selloff in both the pound and British government bonds, a sign that investors are nervous about British assets broadly and uncertain what risks the country’s politics might hold.
The rise of “political risk” is a new phase in Britain’s Brexit drama. It could be bad news for would-be buyers of U.K. assets—or potential opportunities for investors with iron stomachs.
“I thought 10 years ago it was plainly ridiculous to see political risk priced into developed markets—then you had the euro crisis, now we have Brexit,” said Martin Enlund, chief foreign-exchange strategist at Nordea Markets.
Political risks are usually found in emerging markets but can pop up in the developed world, too. In 2011, a political battle over the U.S. debt ceiling and concerns that Greece would leave the eurozone dragged on equities.
Between the referendum and Mrs. May’s speech, the fall in the pound could largely be explained by the yield of U.K. government bonds, called gilts, falling at a faster pace than the yields of bonds in other developed markets, such as Germany’s bunds.
Lower interest rates, represented by bond yields, tend to weaken a country’s currency, since fewer investors want to buy that nation’s assets.
But since Oct. 2, a gilt selloff has driven up yields from their historically low levels. Yields move inversely to bond prices.
“The markets were somewhat in denial and hoping for the whole notion of Brexit to go away,” said Greg Peters, senior portfolio manager at PGIM Fixed Income. “That speech in particular really turned that around.”
The relationship between the pound and the FTSE 100 has also changed. Britain’s flagship stock index is priced in sterling, but its companies make more than 70% of their revenues abroad, so a drop in the pound magnifies corporate earnings.
In the initial run of sterling weakness, the pound fell 14% against the dollar from $1.498 on June 23 to $1.289 on Aug. 15. That coincided with a 9.5% rise in the FTSE 100.
But between Oct. 2 and Oct. 17, the FTSE 100 rose by around 1.5%, while the pound dropped 5.4%.
The premium for political uncertainty presents reward as well as risk. Even though the FTSE 100 is near record levels, dividend yields are high by historical standards, especially in comparison to the ultralow yields on government debt. Those dividends should be a tempting income stream for investors hungry for reliable payments.
There is a “pretty extreme risk premium relative to history” when valuing British shares, said Mike Bell, global market strategist at J.P. Morgan Asset Management. Mr. Bell said U.K. stocks look “screamingly cheap” based on their cyclically adjusted price/earnings ratio.
The FTSE All-Share index, which measures hundreds of U.K. companies that make two-thirds of their revenues abroad on average, currently trades on a cyclically adjusted P/E ratio of around 13, compared with a long-run average of 17. By the same measure, the U.S.’s S&P 500 stock index has a CAPE ratio of around 27, above its 50-year average of 20.
In the gilt market, analysts such as Anton Heese at Morgan Stanley MS 0.56 % see political risk as the main driver of the jump in yields. “We would be talking about quite a paradigm shift in how gilts have traded against the currency for the last 25 years,” he said.
One sign of mounting political risk is the recent sharp rise in long-term inflation expectations implied by derivatives markets, said Toby Nangle, co-head of asset allocation at Columbia Threadneedle Investments.
“The fact that it’s happening on a U.K.-specific level—it’s a little bit more concerning,” said Mr. Nangle.
Some investors reaped huge returns when political risks abated. The sovereign-bond crisis in countries such as Spain and Italy faded once it became clear the eurozone would hold together, meaning bumper profits for buyers of debt in southern Europe—so long as they didn’t hold Greek bonds before that country defaulted.
But some analysts say markets are pricing in so much political risk for a valid reason. The U.K. faces potentially years of uncertain negotiations.
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Normal valuation models may well suggest the pound has been oversold—indeed, BNP Paribas BNPQY 0.48 % ’ model for a currency’s fair value suggests that sterling should be just slightly below $1.40 in its “middle ground” scenario.
But the opposite is true, Goldman Sachs GS 1.27 % said in a research note on Tuesday.
The bank argues that a so-called hard Brexit, in which Britain loses access to the EU’s single market, would be a “structural break” for the U.K. economy, and the pound could fall as much as 40% relative to its pre-Brexit level.
Others forecast more pain for the pound, the main proxy for U.K. risk.
“I wouldn’t rule out parity” said Marc Chandler, head of currency strategy at Brown Brothers Harriman & Co. “This is an existential crisis” for the U.K.
—James Mackintosh contributed to this article.
Write to Mike Bird at Mike.Bird@wsj.com and Christopher Whittall at firstname.lastname@example.org