With the machinations of the last year, the phrase ‘political uncertainty’ has rapidly come back into vogue when discussing stock markets. Although the term is slightly vague, the prevalence of uncertainty in the market place can now be measured and has more recently been categorised through the innovative ‘Economic Policy Uncertainty’ set of indices. Unsurprisingly these indices have been surging in recent months, but should we be worried?
Uncertainty reflects the unknown, an uncomfortable and unquantifiable environment where assigning probabilities to future events with any confidence becomes almost impossible. Uncertainty makes it difficult to balance risk and return appropriately and it has, on occasion, foreshadowed market downturns and volatility.
Intuitively this makes sense. Investors typically buy and sell based on how they see any particular company performing in the future. Unpredictable uncertainties make the future more difficult to forecast. Investors are less willing to pay for uncertain returns and, all else being equal, prices in risky assets normally fall.
In addition, uncertainty can also affect the ‘real’ economy. When businesses or individuals perceive uncertainty they become more reluctant to commit capital. Brexit provides a convenient example with its myriad of possible outcomes for a company. For a company unsure of Britain’s future place within global trade, building an expensive plant, for example, could perhaps prove to be a costly mistake. A more sensible strategy might be to wait until negotiations are underway and the level of uncertainty has diminished. If every firm took this view it could clearly potentially cause a broad-based short term decline in economic activity.
Given the above, it seems counter intuitive that markets have continued their record breaking trend upwards. As with all things, however, it is worth looking at the bigger picture.
Take Donald Trump, who has undoubtedly created a maelstrom of uncertainty. However, it is important to remember that Trump is potentially still seen as a business friendly president, with a populist agenda that should provide a short-term boost in output, employment and real wages, even if he has trouble delivering anywhere near his full mandate. Business confidence appears unshaken by his eccentric judgement, with the CEO Economic Outlook Index only increasing since the election.
More importantly, economic data and corporate earnings in the US have also continued to show resilience. Although markets are supposed to hate uncertainty, a mix of uncertainty and good data is much more preferable to certainty and poor data.
Brexit represents a slightly more complex scenario. Without writing an entire thesis on the matter, it is sensible to note that while political uncertainty has undoubtedly had some effect on the real economy, it is far from the apocalyptic scenario imagined by some.
How markets reacted in the aftermath is perhaps more significant. As many would have noted, sterling devalued following the vote and as around 71 per cent of revenues in the FTSE 100 are denominated in foreign currencies, this led the index broadly higher. Fortunately, this global nature not only acts to diversify their cash flow but also provides insulation against the influence of home grown political decisions. Conversely, some of the more domestically focused companies suffered, but anyone who invested at these attractive valuations would have been well rewarded now, which tells us that political uncertainty can also create opportunities.
Another relevant by-product over recent months is the number of companies announcing plans to move operations away from the United Kingdom if Brexit negotiations prove unfruitful. While the economy may suffer from such an exodus, this emphasises that in today’s interconnected world, businesses can be increasingly nimble in how they deal with political uncertainty.
As investors, we must remember that we invest in companies, not countries. Businesses can move far faster than politicians often can and with new companies like Airbnb, Uber and others, globalisation’s march forward is unlikely to be halted.
News articles will continue to focus on political uncertainty, it’s their job to sell bad news. While we should never ignore or become complacent about such uncertainty, we must continue to place it in the wider context; balancing it with any number of other dynamics that could affect future trends in stock markets. The actual valuations of assets are by far a bigger driver of future long term investment returns, compared to either economic news or political uncertainty in the short term.
Giles Marriage is director of institutional sales at Thesis Asset Management