Uncertainty Principle

Risks to economic growth

The recent surge in economic and political uncertainty is likely to push the UK into recession and poses downside risks to European and US growth.

If you know where something is, you cannot tell how fast it is travelling.

That’s the basic gist of Heisenberg’s Uncertainty Principle. We have a good idea of how advanced economies were doing in the run-up to the Brexit referendum – they were holding up reasonably well with unemployment trickling down. But how fast are they deteriorating after the Brexit result?

 

We think the UK is sliding into recession... even a 2x average jump in uncertainty can knock at least 0.5% off growth

chart showing a spike in economic policy uncertainty in 2016

We think the UK is sliding into recession. A measure of economic and political uncertainty based on newspaper articles has spiked to more than 6x average. We find that even a 2x average jump in uncertainty can knock at least 0.5% off growth, primarily through weaker business investment. Not only are companies reluctant to invest but banks become more cautious about lending too.

 

While we have no official data, anecdotes abound of companies and households cancelling expansion plans and property deals. So the UK economy is in severe danger as uncertainty is likely to persist. We have no idea what arrangement we will have with Europe in the future. We have a new Prime Minister. The opposition is in disarray. Even Nigel Farage has resigned as leader of UKIP!

European uncertainty jumped to 3.3x average in June too.

There are downside risks in Europe too. Not only through direct trade links with the UK, but once-bitten twice-shy markets are also likely to be wary of a forthcoming referendum in Italy (and the PM has threatened to resign if he loses, paving the way for a potential anti-euro Five Star government) as well as general elections in France, Germany and the Netherlands next year. European uncertainty jumped to 3.3x average in June too.

 

Even the US, on the other side of the Atlantic, is not immune. Political uncertainty is 2.3x average there. Although the US should be less bothered by intra-European spats and news coverage of that should fade, the forthcoming race for President between Maverick Donald Trump and Hilary Clinton should keep US uncertainty heightened, particularly if Trump wins and threatens to dismantle trade deals.

Maverick Donald Trump should keep US uncertainty heightened

Historically, jumps in uncertainty have reversed quickly (e.g. after September 11, Iraq War), limiting the pain. But this partly reflected policy easing. If uncertainty remains heightened for longer, this just reinforces the lower-for-longer theme on interest rates.

 
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