Stock markets have responded well to Joe Biden’s election victory. There’s a reason for this, shown in my chart.
It shows the dividend yield on the All-Share index plotted against an index of global policy uncertainty compiled by Scott Baker, Nick Bloom and Steven Davis. There’s a huge correlation between the two, of 0.68 since Baker, Bloom and Davis’s data began in 1997. High policy uncertainty means a higher dividend yield and therefore lower share prices. Since Mr Trump’s election in 2016 such uncertainty has been much higher than in the past, to the detriment of equities. The election of Mr Biden raises the hope that uncertainty will fall back, thereby boosting prices.
You don’t need to be an admirer of Mr Biden to believe this. Yes, as a conventional mainstream politician he is more amenable and familiar to much of corporate America and Wall Street – a fact which alone should reduce uncertainty. But it is the political mainstream that for years presided over the stagnation in ordinary Americans’ living standards – a stagnation that contributed much to Mr Trump becoming president.
The impact of reduced uncertainty on equities could be big. The post-1997 relationship suggests that if policy uncertainty falls by one standard deviation (which would still leave it well above its long-term average) then the All-Share index should rise by over 11 per cent – equivalent to over 600 points on the FTSE 100.
Common sense tells us that policy uncertainty should be bad for equities. For one thing, the cliché is true. Markets do hate uncertainty, and investors demand a high risk premium for taking it on. If uncertainty falls, therefore, so too should the equity risk premium – which means rising prices.
Also, uncertainty can do real damage. As Professor Bloom has shown, it causes some companies to postpone investment and hiring plans. Even if it is profitable to expand, why should a company do so when there is huge uncertainty if it has the option of delaying until the uncertainty lifts, when it might become even more profitable? Lower uncertainty should therefore raise economic growth, to the benefit of equities.
Whatever your opinion of Mr Biden, then, we have good reason to expect his presidency to raise share prices, perhaps by a lot.
Or have we? Policy uncertainty is not merely Mr Trump’s creation. It is also the product of the environment – a fact that could keep uncertainty high.
Most obviously, Covid-19 will still be with us when Mr Biden becomes president on 20 January. This alone ensures uncertainty about how he will control it. Yes, there is now hope for a reasonably effective vaccine. But can this really be rolled out quickly across the country given the nation’s substandard healthcare system and substantial minority of anti-vaccination conspiracy theorists?
But there’s another, deeper source of uncertainty. Even before the pandemic the US was stuck in what former Treasury Secretary Larry Summers calls “secular stagnation” – an era of underlying weak growth in which expansion depends upon loose monetary and fiscal policy.
Exactly how it entered this baleful condition is a matter of debate. It could be that the financial crisis had a long-lasting effect in depressing animal spirits. Or it could be that, as Northwestern University’s Robert Gordon has argued, big transformative innovations have dried up. Or perhaps rent-seeking, lobbying and cronyism have reduced the creative destruction that drives economic growth, as New York University’s Thomas Philippon has documented in The Great Reversal. Or it could be that the profit rates of many US companies have fallen so far as to extinguish the incentive to grow.
Whatever the reason, though, the conclusion is the same. The fate of the economy is more than usually dependent upon supportive fiscal and monetary policy. This increases the danger of a policy error. Which in turn will keep policy uncertainty high.
So yes, Mr Biden’s victory offers markets hope. But this must be tempered by the realisation that politics is not merely a matter of individuals. It’s also about structural forces. And some of these are nasty for equities.
