Why Uncertainty Isn’t the Real Threat for Markets

Markets should be used to uncertainty by now. They might have more to fear from clarity.

The view across the Thames from the New Tate Modern’s viewing platform on June 14, during those last simple days before Brexit. PHOTO: REUTERS

By RICHARD BARLEY
Updated July 27, 2016 3:52 a.m. ET

If there is one thing the world seems to be producing in abundance, it is uncertainty. It is said that markets hate uncertainty, but resolution might be the real problem.

Last week, European Central Bank President Mario Draghi used the word “uncertainty” or a variant thereof 13 times in his press conference, including five times within the space of 30 seconds. The Bank of England’s minutes are littered with references to the uncertain outlook generated by Brexit. A media-based measure of European policy uncertainty maintained at policyuncertainty.com shot to the highest reading on record in June.

But it is worth breaking down uncertainty as a concept. Higher uncertainty in a pure economic sense is an increase in the range of outcomes that are possible around a central case, notes Aberdeen Asset Management economist Paul Diggle. This could mean opportunity as much as threat. What arguably matters more for markets is a shift in the central tendency within the range of outcomes. That represents a shock to confidence, not uncertainty.

For instance, data compiled by the U.K. Treasury show 20 organizations submitted forecasts in both June and July for 2017 growth. In June, their forecasts stood between 1.2% and 2.7%—a range of 1.5 percentage points. But in July, in forecasts submitted after the Brexit vote, that gap had widened to 3.5 percentage points, with forecasts ranging from minus 1.3% to 2.2%. The shift downward in expectations is the problem more than the wide range of outcomes: The outlook is gloomier than before.

Monetary policy traditionally would look to smooth both ends of this distribution, reining in the economy during booms and supporting it during busts. For central bankers, the problem is the persistence and multiplicity of shocks in the post-financial-crisis world. There has been a constant need to attempt to prevent the worst-case outcome from becoming reality. That is a counterweight to uncertainty for markets. But consistently subpar growth has had the effect of reducing conviction among investors: the upside may be capped just as much as the downside.

Higher uncertainty about the future and persistently sluggish outcomes may be partly responsible for markets in which assets that have more predictable cash flows are in demand. This is an alternative way to read the “search for yield.” It is as much a result of economic uncertainty as the policy response to it. Hence, investors continue to favor corporate bonds, and stocks where dividends are reliable. Meanwhile, sectors where there are multiple sources of uncertainty, such as banks that face economic, regulatory and political pressures, are laggards.

The greater risk to markets in fact looks like a reduction in uncertainty—either through a crisis that policy makers prove unable to address, leading to economic damage, or through an improvement in the growth outlook, perhaps by combining fiscal and monetary policy. Investors’ current approach to markets would face a test in either case.