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Behind the numbers: Measuring the uncertainties of Brexit

The need to look beyond traditional sentiment indicators has changed

Over the past few years, a wave of populism and protectionism has swept across many developed markets. Events such as the Brexit vote and the US presidential election in 2016 have had large and long-lasting effects: the US-China trade war, UK parliamentary upheaval around Theresa May’s numerous rejected deals, immigration and tariff repercussions, and the Mexican and Irish border disputes.

Politics has significant implications for markets and economies as it may
require companies to adjust their operations and supply chains which is a slow, sometimes painful, process but remains, to a large extent, unknown. Despite this lack of clarity, we are in an era where news reaches the public in real time; political manoeuvring and the uncertainties around it has become more important to investors.

Risk investors can relate to fundamentals surrounding a company’s ability to generate profits, as well as sentiment relating to the company and the external environments in which it operates. The economy has traditionally been the primary external factor affecting investor sentiment. Politics, however, has recently developed increasing significance but it is not as well-captured in hard data.

Looking at historical performance, volatility, asset prices and politics should provide some insight. Chart 1 looks at two traditional measures of investor sentiment – the volatility implied by UK stockmarket prices as well as the sterling/US dollar exchange rate with low volatility and a strong exchange rate typically signalling that investors are calm.

From the FTSE Implied Volatility Index and the GBP-USD exchange rate, “risk-on” sentiment was evident in market behaviour during the global financial crisis. This is indicated by a spike in implied volatility as well as a sharp change in the GBP-USD currency pair in 2008/09. However, following the EU referendum, negative sentiment was significantly less evident. Sterling depreciated versus the dollar, however the FTSE IVI hardly moved.

Political uncertainty

One reason why traditional indicators are not capturing political uncertainty is that there has never been the need to because most periods of uncertainty in the past have been economic in nature. Prolonged political uncertainty is a relatively recent phenomenon which has closely coincided with the rise in technology and social media.

Where political uncertainty has historically existed, it has been short-lived. The 9/11 terrorist attacks sent political reverberations through stockmarkets and produced a greater reaction in UK volatility than the EU referendum.

Following 9/11, investors were able to make sense of events and move on but have not managed to do so with Brexit given the prolonged period of uncertainty it has created.

It would clearly be useful to measure uncertainty given how closely it relates to economic phenomena, and academics have begun to grapple with quantifying the unquantifiable. Adopting a data-driven approach is the UK Economic Policy Uncertainty Index which aims to track the proportion of news articles referencing policy uncertainty across 11 leading newspapers in the UK. This methodology stems from the world of big data where computers screen and record references to specified words and phrases that characterise uncertainty.

Chart 2 reveals the EPU and IVI have tracked a relatively similar path with both peaking in 2008 and 2010 during the GFC and the Greek debt crisis. However, they diverged significantly following the EU referendum in 2016 as the EPU surged, remaining elevated before declining towards the end of 2018, spiking again in January 2019 following the first parliamentary rejection of Theresa May’s Withdrawal Bill.

We do not expect data-driven indicators to be perfect. However, the EPU lends itself reasonably well as a measure of investor sentiment and political uncertainty.

Considering the EPU Index alongside the positive returns for the FTSE All Share since the referendum, one cannot help but ask whether this relative performance is the reward for investors assuming Brexit risk or, is the market underestimating the level of uncertainty and risk?

Providing some insight is a survey of roughly 7,500 UK company executives conducted by the Bank of England, the University of Nottingham and California’s Stanford University which has been under way since 2016, tracking how Brexit is affecting their companies.

Brexit effects 

The assessment of uncertainty ascertained that Brexit has created “a large and persistent uncertainty shock” for businesses which have found it difficult to quantify the possible effects of Brexit and are more concerned with the long-term implications, which is evident in lower investment growth as businesses hoard resources to maintain adaptability.

It is possible that we are yet to endure the true effect of Brexit. The uncertainties of it and the weak impact it has had on traditional measures of sentiment indicate that its impact will likely be a “second-moment effect” felt in the long term.

The uncertainties of Brexit have manifested in prolonged concerns which are clearly felt within markets today, yet many sentiment indicators are not capturing these emotions. Attempts to measure uncertainty have reported that it is at record high levels but also that the true effects of Brexit are likely to be felt down the line, which is important for investors in UK equities to consider.

Amy Kennedy is fund analyst at FE

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