The costs of political uncertainty

When and by how much will the Bank of England raise interest rates? Will the government need a plan B (or C or D) to fight Covid over the winter? Will it renegotiate the Northern Ireland protocol? Will the Prime Minister even remain in office? Merely asking these questions reminds us that while political uncertainty has declined recently, it could re-emerge – a fact that matters a lot for equities and the economy.

We have a measure of policy uncertainty, an index compiled by Scott Baker, Nick Bloom and Steven Davis. It shows that uncertainty has fallen to its lowest level since 2014, thanks to reduced uncertainty about the policy response to the pandemic and about Brexit. This fall in uncertainty during the past 12 months has been accompanied by big rises in many stocks, especially in the transport and travel sectors.

Which is no coincidence. My table shows that many parts of the market are economically and statistically significantly sensitive to variations in policy uncertainty. A one standard deviation rise in uncertainty is associated with big falls in retailing and transport stocks in particular – more than can be explained merely by the fact that uncertainty is bad for equities generally and these sectors are sensitive to moves in the general market.

As you’d imagine, it is cyclical sectors vulnerable to changes in lockdown policies or to the quantity of red tape that are most sensitive to policy uncertainty. And there are some sectors that are insensitive to it. These tend to be either defensives such as utilities or beverages or ones that operate largely outside the UK and so are unmolested by domestic politics such as tobacco, oil or miners.

The impact of political uncertainty does not, however, stop at its impact on share prices. If equity investors are loath to invest in cyclical sectors when uncertainty rises, you’d expect company bosses to also be loath to invest and expand.

This isn’t simply because in depressing share prices uncertainty raises the cost of capital (although it does). It’s also because uncertainty is itself inhibiting. If you can’t be sure whether an expansion will be profitable, you’ll delay it until the uncertainty lifts. For this reason, says Bloom, “uncertainty damages short-term growth”.

Serious politicians such as Margaret Thatcher and Gordon Brown knew this. They were keen on stability (although they ultimately failed to deliver it) because they knew uncertainty was economically damaging.

Looking only at listed companies, however, understates the damage done by policy uncertainty. Listed companies are generally larger than others and have the planning departments, spare capacity and management time that better equip them to cope with uncertainty. Smaller businesses struggling to get out orders and make the payroll each week lack that flexibility. Red tape is a fixed cost that falls more heavily on smaller companies than larger ones. And smaller companies have seen a huge increase in their debt: Bank of England data show that firms with a turnover of less than £25m have seen their debt rise by more than 25 per cent since the start of the pandemic. Such increased leverage means they are more fragile and hence more vulnerable to uncertainty.

In all these ways it is smaller firms, more so than larger ones, that suffer from uncertainty. By the same token, it is they that benefit more from the decline in uncertainty we’ve seen in recent months. But this is only a good thing if it persists. Will it?

To a large extent we cannot say, because the biggest problem in politics, as Harold Macmillan allegedly said are “events, dear boy”.

But there’s one thing we do know: political uncertainty tends to rise in economic downturns and fall in recoveries. Causality runs in both directions. Increased uncertainty cuts output, but also recessions create uncertainty because we don’t know how policymakers will react to it.

Which brings us to a danger. It’s likely that economic growth will slow down in the next few months. This is partly because overseas economies are slowing: indeed, Alex Bryson and David Blanchflower believe the US might be entering recession. But it’s also because higher gas and petrol prices are squeezing spending power and because fiscal policy is tightening: the Office for Budget Responsibility (OBR) says cyclically-adjusted net borrowing will fall by 4.4 percentage points of gross domestic product (GDP) in 2022-23.

Slower growth in itself is bad for equities. If it leads to a return of policy uncertainty the impact will be even greater. We must not, therefore, take our current calm for granted.