Worries should rise when complacency builds

Thinking Aloud

A new Bank of England index measuring uncertainty shows investors are remarkably complacent about Brexit.

The Bank’s Quarterly Inflation Report now contains an uncertainty index. It pulls together a range of market, survey and forecast variables to show how much uncertainty there is during a particular month compared to the historical average (or what you could consider to be ‘normal’ times). It is measured in standard deviations. A reading of zero means that there is no more uncertainty than normal; one means that uncertainty is one standard deviation above normal.

The index shows that in July (the most recent data available) uncertainty was around 1.5 standard deviations above normal. It was 2.5 standard deviations above normal during the financial crisis, so there’s currently about 60% of the uncertainty that we had during the financial crisis. This makes intuitive sense. The country has just unexpectedly voted to leave the European Union, lost a Prime Minister, gained a new one, and seen a phalanx of politicians coming and going across the political spectrum. But, at the same time, Brexit is not akin to the tumult of the financial crisis.

In other words, investors think there’s barely any more uncertainty now than normal.

But, stripping everything back to just look at the market variables, a very different picture emerges. According to these variables, uncertainty is just 0.3 standard deviations above normal. In other words, investors think there’s barely any more uncertainty now than normal.

These market data are refreshed daily, so we can get a clearer picture of what is driving this complacency. Market uncertainty peaked on 14 June, as the referendum polls narrowed and the possibility of Brexit suddenly became very real. It then peaked again on the day that the result was announced, for obvious reasons.

But uncertainty started to fall away by the start of July. By this point Mark Carney had stepped in to say that the Bank had a plan and would act if the economy began tanking. The government said it would act in the Autumn if necessary too.

This twin reassurance of monetary and fiscal stimulus seems to have soothed investors, as they began to bet that the Bank and government would deliver. The market measures of uncertainty consequently kept dropping. This trend continued through the Bank of England meeting on 4 August, when Carney delivered on his reassuring words.

worries should rise

This cratering in uncertainty suggests that investors think that the Bank’s measures, and whatever the government might come up with in the Autumn, will work. But there’s only so much that the Bank of England can do. Much ink has been spilt on the subject of central banks running out of tools; and much of it is right. As for the government, we don’t even know what they will or won’t do, let alone whether it will work.

On the face of it, the sharp drop in market uncertainty is testament to the power of central bankers and the government to support the economy and soothe investors. But in the face of so many unknowns, and with the potential for disappointment huge, markets could prove overly complacent.

By Paul Diggle, Economist.  This article was first published on 19 August 2016 on the Aberdeen Assest Management ‘Thinking Aloud’ blog.