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The cost of uncertainty

Political uncertainty imposes huge losses upon equity investors, and markets could rise a lot if it declines
The cost of uncertainty

Political uncertainty is costing UK shareholders hundreds of billions of pounds. My chart shows why. It plots a measure of global policy uncertainty compiled by Scott Baker, Nick Bloom and Steven Davis against the dividend yield on the All-Share index. There is obviously a strong link between them. Falls in policy uncertainty in the late 1990s, mid 2000s, 2009-10 and in 2013-15 were all accompanied by falling dividend yields. And rising uncertainty in the early 2000s, 2008-09, 2011 and last year all saw the dividend yield rise.

Policy uncertainty, therefore, cuts share prices. This link implies that if policy uncertainty were to fall back to its post-1997 average, the dividend yield on the All-Share index would fall by a percentage point. That implies a 30 per cent rise in share prices. To put this another way, above-average uncertainty is depressing UK share prices by the equivalent of £650bn.

Granted, this raw correlation overstates the cost of policy uncertainty. Some of this reflects fundamental economic uncertainty – of the sort we saw in 2008-09 – which would depress share prices anyway. Policy uncertainty was high after the 2008 banking crisis not because politicians were playing silly beggars, but because the economic climate and the required policy response were genuinely uncertain.

Not all policy uncertainty, however, is of this type. Some of it is unnecessary, such as US-China trade tensions and the mishandling of the Brexit negotiations. Such exogenous uncertainty is surely depressing share prices.

And it’s also raising bond prices. There’s a strong negative correlation between this measure of policy uncertainty and longer-dated index-linked gilt yields: higher uncertainty is associated with lower yields. This is simply because in uncertain times investors shift into assets they believe to be safer. For this reason, policy uncertainty is especially bad for shares that are most sensitive to investor sentiment, such as Alternative Investment Market (Aim) stocks.

This doesn’t mean that policy uncertainty adds to stock market volatility. It doesn’t – the correlation between this measure of uncertainty and the Vix index is insignificant. There’s a simple reason for this. Stock market volatility is a sign of how much investors agree. If we all agree the outlook is bad we’ll all try to sell and prices will fall a long way before buyers emerge, whereas if we disagree sellers will quickly find buyers and so prices won’t move much at all. Policy uncertainty is as likely to generate disagreement and hence low volatility as agreement and high volatility – if, say, some investors think the trade war will be resolved satisfactorily while others don’t.

It’s very likely that such uncertainty is doing real economic damage beyond simply depressing share prices. It’s also weakening economic activity and not merely because lower share prices mean we are poorer and therefore spend less.

Policy uncertainty depresses business investment. Just as it makes shareholders reluctant to invest in risky assets so it also makes company managers reluctant to invest too. Instead, they’ll prefer to delay investments until the fog of uncertainty has lifted. Stanford University’s Nick Bloom and colleagues have estimated that Brexit uncertainty has depressed business investment (relative to what it would otherwise have been). And lower investment means lower productivity growth and hence lower real incomes for us all.

There was a time when politicians knew this. Margaret Thatcher and Gordon Brown did not agree on very much. But they did agree on something: that economies performed better when governments provided policy stability. As the Iron Lady said: “An economy will work best when it is built on a framework of clear and predictable rules on which individuals and companies can depend when making their own plans.” Her successors – not just in the UK – have forgotten this.

Herein, though, lies what might be good news. All of this implies that if we do see a fall in policy uncertainty then shares could recover strongly. We’ve already had a taste of this. Global policy uncertainty has fallen since December, thanks to the ending of the US government shutdown and signs of an easing in US-Chinese trade tensions. And shares have risen nicely: the FTSE 100 is 9 per cent up from its December low point. If the uncertainty falls further – say because fears of a trade war recede further or if progress is made on Brexit – then we could see a further rise. This would, however, happen in much the same way that a man will take deep breaths if you take your foot off his windpipe.