It's very quiet out there

As UK political uncertainty mounts, it is striking that sterling-denominated assets have held up reasonably well of late. Sterling has traded in a relatively narrow range over the past year with the trade weighted index registering a high of 79 in May and a low of 74 in August. Surprisingly, investor net speculative positions in sterling, which were heavily negative early this year, have now turned flat to slightly positive. This reflects the fact that FX investors are currently not expecting a significant sterling collapse, although the timing of the move does appear to be correlated with changes in the market’s position on BoE rate hikes. Meanwhile, although the FTSE100 has trailed indices such as the Eurostoxx  50 year-to-date, they have moved broadly in line since May and the FTSE has managed a year-to-date return of 3.8%  – not great when set against other markets but nonetheless positive. Moreover, the weakness of sterling tends to be a positive factor for UK equities given how much revenue is booked in foreign currencies (around 70%).

Thus, political uncertainty appears to be conspicuous by its absence so far as markets are concerned, which reflects the fact that investors are looking through all the rhetoric and concluding that the likelihood of a cliff-edge Brexit is low. Since we are still more than 16 months away from the expiry of the Article 50 negotiation phase, markets take the view that there is no sense in panicking now – there will be plenty of time for that later. Nonetheless, the closer we get to the deadline without agreement, the greater the likelihood that assets will come under pressure, but that is probably a story for next year.

To get a sense of how the market and economic agents assess uncertainty in the UK at present, I constructed an uncertainty index based upon eight variables: (i) FTSE100 equity volatility; (ii) EUR/GBP FX volatility; (iii) GBP/USD FX volatility; (iv) the Baker, Bloom and Davis policy uncertainty indicator; (v) GfK survey data for expected consumer finances; (vi)  expected unemployment and (vii) expected economic situation. The final component is (viii) the CBI’s estimate of uncertainty as a factor limiting capex. Furthermore, if we strip out the equity and currency vol measures, we have a five variable index of domestic uncertainty.

The chart suggests that the aggregate uncertainty index has dipped back close to its long-term average (2000-2015). Whilst the domestic indicator has not fallen quite as sharply, it is well below its summer 2016 highs with only the Baker et al policy uncertainty index showing any extended deviation. The interesting thing is that this policy uncertainty index is based on an online trawl of newspaper websites looking for various keywords which express uncertainty. To the extent that much of the concern expressed about Brexit has indeed come via the media (not to mention the blogosphere, so I am as guilty as anyone), it highlights the noise inherent in the debate without necessarily shedding much light on how the economy is performing. Indeed, many of the other indicators normalised very quickly, which suggests that most economic agents generally got on with life in the wake of the Brexit vote.

This does not mean to say that everything will remain so quiet. The GfK survey data point to a deterioration in expectations for the future economic situation with sentiment now back at levels last seen in spring 2013. Moreover, with inflation beginning to put the squeeze on consumers, we are starting to see some deterioration in expectations for consumer finances.

It is worth noting that the indicator is not a good predictor of longer-term trends. Even in the early months of 2008, when there were signs that trouble was brewing in the banking sector and the economy was losing some momentum, both the aggregate and domestic uncertainty indices remained at low levels. A lurch towards the cliff-edge of Brexit could change perceptions quite markedly. Perhaps UK consumers and corporates need to hurt even more before they realise the potential economic consequences of Brexit. This is why just looking at the current relative stability of the uncertainty index is not necessarily a good guide to future trends. In my view – and that of most of the economics profession – a number of senior British politicians do not seem to understand the risk they are taking with the wider economy. It is incumbent upon them to get it right or the electorate may be in a less forgiving mood than it has been of late.