By Helen Reid
LONDON (Reuters) - British shares suffered their worst day's drop since the aftermath of last June's Brexit referendum, after Prime Minister Theresa May said she would call an early election.
The FTSE 100 <.FTSE> dropped 2.5 percent to its lowest in nearly 10 weeks as sterling inched higher, further weighing on the index's stocks, most of which earn in foreign currencies.
The day's losses shrank year-to-date gains for the FTSE to just 0.2 percent, further denting an already weakening rally which had pushed it to record highs in recent months.
The FTSE banking index <.FTNMX8350> hit its lowest level in more than four months, down 2.2 percent on the day. FTSE volatility <.VFTSE> rose to its highest since early December, though it stayed near historically low levels.
Britain's May called for an early election on June 8, saying it was the only way to guarantee political stability for years ahead as Britain negotiates its way out of the European Union.
"If we have a stronger government pushing for a 'hard' Brexit, markets won't like that. But on the positive side, you would have more stable government for the UK," said David Stubbs, global market strategist at JP Morgan Asset Management.
"Financial markets have clearly rendered their judgement of [the Brexit process] through sterling," he said.
"Loss of single-market access, if it happens, necessitated a cheaper currency, that's the calculation markets made."
Traders said the election could eventually lead to a stronger sterling if May's majority was strengthened and policy became more predictable.
Long-standing sterling bear Deutsche Bank called the election news a 'game-changer' for the currency, saying it would revise up its forecasts.
This spelled uncertainty ahead for the blue-chip index, which had been helped to record highs by sterling's weakness.
The snap election and a likely strengthening of the currency could be positive for mid-cap companies, however, which make more of their revenues in sterling, UK equities managers at Henderson said.
Lower metals and crude-oil prices were already weighing on the commodities-heavy FTSE 100 before May's announcement.
Mining companies Anglo American , Glencore , Antofagasta , Rio Tinto and BHP Billiton dropped as Chinese iron ore futures fell to three-month lows, with oversupply worries weighing on steel prices.
Oil major BP was also a top faller, down 3.5 percent as the price of crude fell after a U.S. government report indicated rising production.
The more domestically focussed mid caps <.FTMC> and small caps <.FTSC> outperformed the blue chips, falling 1.1 and 0.5 percent respectively but holding near record highs reached in the last trading session.
"People have been pleasantly surprised by how sanguine companies' management teams have been," said Ian Williams, economist and strategy analyst at Peel Hunt.
"In the last six weeks, the mood of companies presenting has been much more optimistic, and people are asking whether some of the risk has been priced in already."
The top mid-cap fallers were all commodity-linked stocks, led by iron ore pellet producer Ferrexpo , down 11.5 percent, and miner Vedanta Resources, down 8 percent.
Emerging markets-focused fund manager Ashmore fell 5 percent, despite earlier posting net inflows for the first time in nearly three years.
(Reporting by Helen Reid; Editing by Andrew Roche)