Quantifying political uncertainty

Chris Dillow

Chris Dillow

UK investors face lots of uncertainty in the next few months: a general election; a possible referendum on EU membership; and the question of whether they’ll even be a UK at all. The impact of such uncertainty upon equities can be quantified, and it is significant.

Scott Baker and Nick Bloom at Stanford University and Steven Davis at the University of Chicago have compiled an index of policy uncertainty based upon the volume of newspaper articles discussing it. Their index for the UK is closely linked to the dividend yield on the All-Share index. Since January 1997 - when their data starts - the correlation between their index and the yield has been 0.49. That’s as strong a correlation as there is between the yield and inflation.

For example, low uncertainty in the late 90s and mid-00s was associated with low yields and high share prices, and rising uncertainty in 2002-03 and in 2008-09 saw dividend yields rise and prices fall.

Now, correlation is not causality. It might be that bad economic times cause both lower share prices and increased uncertainty as we wonder what policy-makers might do about the economy. But this probably isn't the whole story. The link between policy uncertainty and the dividend yield remains strong and significant even controlling for inflation and unemployment. This implies that economically-induced policy uncertainty might not be the only reason for the correlation. It might instead be that, to some extent at least, policy uncertainty is exogenous and has an adverse effect upon share prices.

How adverse? A simple regression tells us that a one standard deviation rise in uncertainty (controlling for inflation and unemployment) is associated with a 0.29 percentage point rise in the dividend yield. That’s an 8 per cent fall in share prices. A two standard deviation rise in policy uncertainty – which would take the index to record levels - would take 16 per cent off share prices.

Whether this is a lot or a little is hard to say; 0.29 percentage points is half a standard deviation in the dividend yield. And this might be the upper limit of the effect of policy uncertainty, if the correlation runs the other way (with lower share prices creating policy uncertainty) or if there’s some other factor which raises uncertainty, inflation and unemployment.

Even if policy uncertainty does have a big impact upon shares, though, investors shouldn’t complain. Political uncertainty is an unavoidable fact. Complaining about it would be like fish complaining that water is wet.

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