“Markets hate uncertainty” is a cliché. But it is true, and important – and perhaps a reason for optimism.
I say so because there is a massive correlation between equity valuations and policy uncertainty, as measured by Scott Baker, Nick Bloom and Steven Davis. Since 1998 the correlation between their measure of global policy uncertainty and the dividend yield on the All-Share index has been 0.69, implying that fluctuations in policy uncertainty alone can explain almost half the variation in equity valuations.
For example, low uncertainty in the late 1990s, mid-2000s and in 2014-15 was accompanied by high valuations, while high uncertainty in 2008-09, 2011-12 and since 2016 all saw low valuations.
This relationship implies that if policy uncertainty were to fall to its long-term average the dividend yield would fall to 3.3 per cent which would raise share prices by 45 per cent. This suggests that equity valuations are low now not because the market is pricing in low growth, but simply because uncertainty is so high. It also suggests that political uncertainty is costing holders of UK equities over £800bn.
But why does political uncertainty matter so much?
Our old cliché is one reason. People hate unquantifiable dangers. The problem here is not merely their impact upon the aggregate market, but upon the pattern of earnings growth. Uncertainty about the path of Covid-19, about Brexit or about US-Chinese relations introduce even more uncertainty into the question of which sectors to favour or not. That encourages investors to stay on the sidelines.
There’s also a form of halo effect. Even if political uncertainty didn’t directly affect the market, it would colour our mood. Uncertainty about politics increases our uncertainty about the world generally, and that depresses our willingness to buy equities.
What’s more, as Professor Bloom has shown, political uncertainty reduces capital spending as companies postpone some investment decisions until the fog lifts. This depresses economic growth. Which means dividend yields should be higher to compensate for low dividend growth.
There is, however, a complication here. Political uncertainty is not entirely exogenous. It’s also partly the product of the environment. Policy uncertainty rose in 2008-09 not because the quality of government suddenly deteriorated, but because the financial crisis meant it became much harder for everybody to decide what the best policy should be.
The same applies now. Even if we had adequate governments in the UK and US policy uncertainty would be high simply because we don’t know what course the pandemic will take.
Which, oddly, is good news. It suggests that if or when the pandemic fades away – say because we get a successful vaccine – policy uncertainty will fall and shares rise, perhaps a lot. By the same token, though, uncertainty about the pandemic in the next few months could generate lots of equity volatility.
Granted, political uncertainty won’t fall very much. Even after November’s US presidential elections there’ll be continued uncertainty abut US-Chinese relations and about the UK’s relationship with the EU – to mention only the small subset of uncertainties we can foresee.
Nevertheless, the sensitivity of equities to policy uncertainty gives us hope that the market could rise significantly in coming months.
