In a head-scratching moment for economists, investors and politicians, the Brexit vote and President Donald Trump’s election failed to affect equity markets in the same way that political uncertainty generally has during the past 20 years. That got us thinking: Is there something else at work today, or are markets just being overly complacent?
Our analysis of how politics affects the markets
To answer this question, we studied the policy uncertainty indices established by three widely respected US academics – Scott Baker, Nick Bloom and Steven Davis:
- Global policy uncertainty averaged around 83 from 1997 to 2008, with some short spikes around events such as 9/11.
- Since then, the Global Policy Uncertainty Index has averaged about 140. This clearly reflects that the financial crisis turned into a crisis of economic growth – and eventually into a political problem.
- Policy uncertainty was particularly volatile in the UK after the June 2016 Brexit decision: The already-elevated UK index jumped roughly 540 points by July.
Policy uncertainty rose noticeably after the great financial crisis
The global policy uncertainty index moved higher after 2008 and reached its highest level in 2016
Source: AllianzGI Global Economics & Strategy team, Datastream as at July 2017. Global Policy Uncertainty Index data begin in 1997 and are weighted by current domestic GDP. Policy uncertainty indices are calculated by Baker, Bloom and Davis (www.policyuncertainty.com) using a search of the top business newspapers of a respective country or region to construct an index reflecting the volume of news articles discussing economic policy uncertainty.
Political crises have an impact on valuations
When we looked at how politics can affect equity markets, companies and economies, we found reason to focus our analysis on the valuation impact of political shocks, as measured by price-to-earnings (P/E) ratios.
- The most direct transmission channel from politics to equities is via P/E ratios. This makes sense because investors do not like uncertainty – when political events unnerve them, they attach a higher risk premium to a company’s earnings, and its P/E accordingly declines.
- Politics generally affects actual earnings, as opposed to valuations, only when a political crisis runs deep and lasts for a long time.
- It generally takes more than politics to affect a country’s economic cycle – serious, structural uncertainties need to persist. When this happens, it may be hard to determine whether it was the economic downturn that caused political troubles or the other way round.
For 20 years, political shocks have hurt the markets
As we focused on valuations, our assessment showed that from 1998 until spring 2017, widespread increases in political uncertainty had a meaningful negative impact.
- During this time, the forward P/E ratio of the MSCI World Index fell by 2.6 points for every 100-point jump in global policy uncertainty.
- For the same period, there was a harsher reaction in the MSCI Europe Index to increases in the local uncertainty index (-2.1 P/E points) than the US had to its own uncertainty index (-1.7 P/E points). We assume this is because during that time, Europe suffered from acute political event risks, such as the European debt crisis of 2011-2013.
Higher policy uncertainty means lower P/E ratios
We analyzed 12-month-forward P/Es of various indices over 12 months for every 100-point year-over-year rise in their respective domestic policy uncertainty indices
Source: Allianz Global Investors calculations based on data from Datastream and Baker, Bloom, Davis as at 30/4/2017. Equity/uncertainty index pairings: MSCI World and Global Policy Uncertainty; MSCI Europe and European Policy Uncertainty; MSCI US and US Policy Uncertainty; FTSE 250 and UK Policy Uncertainty.
Brexit and President Trump caused barely a blip
Yet when we looked at the past year as opposed to the past 20 years, we saw much different market reactions. The Global Policy Uncertainty Index surged by about 130 points around the time of Brexit, and by a similar amount when Donald Trump won the US presidential election. Yet not only did P/E ratios barely show a reaction to these events, they even rose slightly for the MSCI World Index.
Why did this happen? Two partially interdependent theories come to mind:
1. Complacency
After a quick shock, the markets probably sensed that neither Brexit nor President Trump would have immediate and indisputably negative consequences. Moreover, after Mr Trump’s win, investors began to look forward to his administration cutting taxes, reducing regulations and repatriating cash from corporations’ overseas accounts.
2. Market and growth momentum
By pure luck, the markets were in an upswing before each of these events. In the summer and autumn of 2016, the markets were revelling in a favorable mix of accelerating macro data, recovering company earnings and accommodative monetary policy triggered by stubbornly low core inflation rates.
Why we believe markets will resume their negative reactions
There are compelling reasons why we think the markets will reassess their sanguine view of Brexit and President Trump in the coming quarters:
- Brexit negotiations have started and they won’t be easy. In the same vein, Mr Trump faces continued political resistance at home, even within his own party, and his stance on many key issues remains unclear.
- The synchronized upswing of global cyclical data is vanishing, with somewhat weaker, regionally different dynamics.
- Major central banks are simultaneously concluding that their economies should be able to get along with slightly less stimulus. Higher rates have almost always cooled down hot markets.
In our view, it is a mistake for investors to think that political risks no longer matter. Rather, the markets’ reality check on recent political surprises might take unusually long.
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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
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