Brexit and the feedback of uncertainty through asset prices

The medium- and long-run consequences of Brexit are unknown, but increased uncertainty in response to the event will likely have real global effects of its own. Individuals are now less confident in their guesses about the future, and this uncertainty changes behavior, increasing risk aversion and decreasing business investment. Global markets reaction to Brexit reflects not only the new average belief about expected future earnings, but also the indirect feedback effects of the higher level of uncertainty.

Medium- and long-term effects unclear

The U.K.’s June 23 vote to leave the European Union, termed ‘Brexit’, surprised many analysts. As the referendum vote neared, markets (representing the average belief of individuals) increasingly expected the ‘remain’ party to win. Some well-educated analysts explained how Brexit would never happen (possibly what Nassim Nicholas Taleb would consider proof of a black swan). The ‘leave’ campaign won with 51.9 percent of the vote, prompting David Cameron’s announced resignation.

The medium-term consequences for the U.K. and E.U. (or anywhere else) are entirely unclear. For example, should unemployment increase and production falter in the U.K. during the next few months, the Bank of England may need to ease monetary policy further and adopt very unconventional tools. However, if the market reaction to Brexit can be fully absorbed by exchange rate adjustment, the Bank of England may need to raise interest rates in response.

On June 24, the pound sterling fell more than eight percent against the dollar (figure 1). In response to the currency depreciation, many here in the U.S. joked about buying goods online from the U.K. or planning vacations. Many others expressed uncertainty about the future of the U.K. and the E.U., and the economic and political implications for the U.S.

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Figure 1. The pound sterling fell against most currencies following the Brexit vote, including by more than eight percent in one day against the U.S. dollar.

Markets reminded of their anxiety issues

Within hours of the ‘leave’ campaign victory, stock prices of some financial services companies, such as Lloyds, fell by 30 percent. Although real changes from the vote may take two years to implement, the average belief about the appropriate cost of equity for these firms changed dramatically overnight. The fundamentals for people and businesses in the U.K. do not immediately change, but their behavior and asset prices do, and this has an indirect feedback effect on the fundamentals

Likewise, the U.S. is clearly not part of the E.U. or U.K., however, it is intimately linked to both markets through trade and investment. The Dow Jones Industrial Average fell 610 points (3.39%) on Friday in response to the news. The most widely-used measure of market volatility jumped nearly 50 percent (figure 2). The sales revenue of the largest U.S. companies is practically unchanged, however, individuals’ collective behavior has changed in response to uncertainty.

Individuals are repricing the assets that they previously overvalued. However, if the Bank of England is forced to wait to decide which direction its key policy will turn, how well can individuals immediately reprice future earnings? The immediate reaction to Brexit reflects not a new certainty about future earnings but increased uncertainty. Individuals never know what the future will hold, but these large unexpected events make them less confident in all of their guesses, and it changes their behavior.

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Figure 2. VIX, the CBOE measure of expected near-term equity market volatility, saw an almost 50 percent daily increase following the Brexit result

Searching for safety and the uncertainty feedback loop

When people are less certain about the future, they take fewer risks. For example, business investment falls when equity market volatility is high. Individual and institutional investors also show preference for safe assets during times of increased uncertainty. In an immediate reaction to Brexit, U.S. treasuries, gold, and Japanese Yen saw inflows, while equity markets saw net outflows. Neither business fundamentals nor any rules had changed; people were showing risk aversion.

Investors’ increased aversion to equity investment raises firms’ equity cost of capital. This cost of capital is a major factor in firms’ investment decisions, especially for smaller and less-cash-flush firms. Therefore, the uncertainty induced asset price shock has a feedback mechanism through which it affects the future value of companies. This dangerous feedback mechanism can be procyclical.

What it means for the U.S.

The medium- and long-term direct effects of Brexit on the U.S. are very unclear. Brexit-induced equity market volatility, higher levels of uncertainty, and the negative effects these entail can however be analyzed with attention to the current U.S. macroeconomic environment. Three potential short-run consequences emerge:

1) Continued volatility in equity markets and strong demand for treasuries;

2) More downward pressure on business investment, which was already negative in the first quarter of 2016; and

3) Delay of the next Federal Funds rate hike in response to the above.

While the downward pressure on already weak business investment is worrisome, none of the above are enough to induce major concern. Households, many of which have recently started seeing long-awaited wage and income increases, will play a key role in determining whether recent asset price volatility will spill into consumer sentiment and awake a much worse set of feedback mechanisms.

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Nearly 100 freshly updated charts:

U.S. Macro and Markets Dashboard (Updated June 26, 2016)

References and additional reading

Networks, Crowds, and Markets: Reasoning About a Highly Connected World by David Easley and Jon Kleinberg

Nick Bloom comment on Brexit 

BBC: The UK’s EU referendum: All you need to know

 

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Dashboard update: Jobs data and new uncertainty

Dashboard PDF file:

Macro and Markets Dashboard: United States (May 7, 2016 — PDF)
Dashboard Update Summary:

Jobs data for April showed payrolls continue to grow, but at a slower rate. Wage data was strong, however, the labor force participation rate gave up much of its recent improvement. Uncertainty surrounding markets and economic policy seems to have increased in the recent week, and fewer economists now predict a Fed rate hike in June. U.S. equity markets were down for the second consecutive week, while corporate bond yields rose and treasury yields fell. Recent data showed improvement in the trade balance from the weaker dollar, however, the recent depreciation trend has also become less certain.

Jobs Report showed slower jobs growth but wage improvement

The U.S. added 160,000 jobs in April, compared with 208,000 in March and 233,000 in February (both previous months were also revised downward). By sector, much of the growth came from the services side, on an annualized basis. Construction jobs, which make up less than five percent of nonfarm payrolls, were up 4.1 percent, while mining and logging jobs continued their decline and are now down more than fifteen percent over the past year (this is the smallest industry sector shown in the figure below, and represents only 0.4 percent of nonfarm payrolls). Weekly data on new jobless claims, as of April 30, showed still very low, but slightly increased, levels.

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The latest jobs report shows continued improvement in both nominal and real wages in practically all sectors. Nominal wages increased most rapidly over the past year in financial services, information services, and leisure and hospitality. On average, wages from the goods sector are higher, largely as a result of low-wage service-sector jobs in leisure and hospitality.

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Equity and Bond market conditions deteriorated

Equity markets were down for the second straight week. The S&P 500 was down 0.4 percent, the Nasdaq composite index was down 0.8 percent, and the Dow Jones industrial average was 0.2 percent lower. Volatility was higher during the week, and the VIX closed Friday at 14.7. The Shiller index of price to earnings ratios was up to 26.02 percent in April from 25.54 in March. Corporate bond yields ticked up during the week. The Merrill Lynch index of junk bond yields was up to 7.56 percent. Ten year treasury yields fell to 1.79 percent.

Economic policy uncertainty improved in April but may revert

Economic policy uncertainty, as measured by Baker, Bloom, and Davis, fell sharply in April, as there was little speculation of Fed action at the April meeting. However, I expect this index to bounce back; uncertainty will increase as the Fed June meeting and Brexit grow closer.

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Oil was down on the week, while April food prices increased

Oil prices closed lower on the week. The U.S. measure of crude oil prices, West Texas Intermediate crude front-month contracts, fell 2.7 percent during the week, to $44.66 a barrel. World food prices from the Food and Agriculture Organization (which I half-jokingly also use as a proxy of political instability) ticked up slightly in April, but remain low.

A weaker dollar improved the trade balance in March

The Fed’s trade-weighted dollar broad index against major currencies fell last Friday (April 29–past week data is released on Mondays) to its lowest level since May 2015. The year-to-date rapid depreciation of the dollar has cut import quantities, as further evidenced in the March data on trade. The trade deficit, which remains roughly 2.2 percent of GDP, improved to -40.4B in March. However, more recent foreign exchange data shows uncertainty about recent depreciation trends. The dollar was stronger against nearly all major trading partners during the past week, notably 1.2 percent against the British pound, 2.76 percent against the Canadian dollar, 3.16 percent against the Australian dollar, 4.5 percent against the Turkish lira, 3,86 percent against the Mexican peso, and 4.3 percent against the South African rand.

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Dashboard update: green shoots in March

Macro and Markets Dashboard: United States (April 2, 2016 — PDF)

The final week of March capped off a month of solid equity market gains and encouraging macroeconomic data. New data shows a continued strengthening of labor markets and a reduction in volatility. Bond yields fell during the week, and the dollar depreciated against most major currencies.

All three major U.S. equity market indices were up more than 6.5 percent on the month, while the Nasdaq composite index climbed nearly three percent during the week ending April 1. Volatility, as measured by the VIX, fell to its lowest level since August 2015. Indeed, nearly all major U.S. asset classes posted gains during the month, following a bearish January and February. West Texas Intermediate (WTI) crude oil prices jumped 13.6 percent in March, though they declined more than 2.5 percent during the most recent week.

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Manufacturing Purchasing Managers Index (PMI) data for March from the Institute for Supply Management (ISM) suggests improvement in manufacturing conditions (see above chart). The PMI, which can be thought of as the weighted percentage of purchasing managers who report positively (above 50 suggests growth), posted its first increase in six months. As a bonus, this monthly report comes with possibly the most pithy explanation accompanying any statistic:

PMI® at 51.8%

New Orders and Production Growing
Employment and Inventories Contracting
Supplier Deliveries Slower

The U.S. economy added 215,000 jobs in March, while unemployment figures ticked up slightly to five percent. However, as evidenced in the dashboard and in previous posts, an increase in the labor force participation rate tells a more complex story than an increase in the unemployment rate. A strong labor market will attract people who are otherwise not participating (someone without a job but not looking for work is not considered unemployed under the headline unemployment figure from the BLS). The labor force participation rate has experienced its first six consecutive months without decline since 2005, as people are being drawn into a decent labor market.

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Across the board, U.S. bond yields fell during the past week. The real yield curve on a five-year U.S. treasury pushed negative, reaching further than a quarter point into the red (see below). The yield on a ten-year treasury fell to 1.79 percent on Friday, from 1.91 a week earlier. Corporate bond yields in all credit segments were also down during the one-week period.

fiveyearrealyield_apr022016

Touching on some additional data, personal and personal disposable income both increased by 0.2 percent in February. The personal savings rate ticked up to 5.4 percent in February, from 5.3 percent in January. As expected, the net international investment position of the United States continued to deteriorate in Q4 of 2015. The economic policy uncertainty monthly index fell nearly 22 percent in March, providing further evidence for a reduction in uncertainty-related volatility.

Lastly, over the past week the U.S. dollar depreciated against all major non-pegged currencies. Notably, the greenback weakened by more than two percent against the Swiss franc and Canadian dollar, more than one and a half percent against the Yen, and around one percent against the Yuan during the five-day period.