The unwilling suspension of disbelief
We have seen some notable political events over the past year. What has marked these out from the more run-of-the mill happenings is that they have introduced greater-than-normal uncertainty. There is a rather trite comment often made by economists and strategists that markets hate uncertainty. In fact, uncertainty is vital to the effective operation of financial (and other) markets. It is only with different opinions about the future, at whatever level this may become manifest, that we can have effective two-way prices. With certainty, we take away the different probabilities that individuals might ascribe to different outcomes and, therefore, any pricing of risk.
In the statistical world, risk refers to volatility. While a particular outcome might be generally expected, given past experience there is a risk that the outcome will be greater or lesser. Generally speaking, statistical estimates of risk are dissociated from whether one outcome might be considered better than another – they are decidedly not value judgements. However, as individuals, we regard risk in a different way. We are rarely neutral with regard to the impact that different outcomes may have on us. And the way we react to perceived risks is not necessarily in line with the probability of different outcomes actually occurring. So, although many people may believe they have a positive attitude towards risk, in reality they are probably not even risk-neutral. While the probability of making 50% on an investment might be equal to the probability of losing 50%, the way we perceive these outcomes will tend to lead to much greater focus on the damaging impact of the potential loss. It may be risk taking that drives advancement, but it is risk aversion that keeps us alive.
Focus on negative consequences
Returning to recent events – in particular, the outcomes of the EU referendum and the US presidential election – they are being regarded as introducing more political and economic risk. And this has to be true. However, there has been much greater focus on the potentially negative consequences of these events – the perceived threats to our national and individual well-being – than the possibly positive effects. Naturally, we fear the impact of disrupting the status quo, and tend to assume that due to this disturbance we will suffer a negative impact. Moreover, to the extent that many people were entirely happy with the existing state of affairs, they do not ascribe a particularly high value to the potentially positive impact of change. But if fear of disturbing the existing way of things were always to determine our decisions, there would never be progress – political, economic, technological, or otherwise.
There is a further problem for many of us when considering the implications of events such as the election in the US of Mr Trump or the UK’s decision to leave the EU. While we may well not like the political and/or social implications of these events, we need to be careful not to allow our concerns at one level to have an overly prominent influence on our interpretation of the consequences at another. So, many people might have concerns about some of the more contentious statements that have been made by the new US President. But this does not mean that his policies will necessarily harm the US or even world economy. Rightly, we should be concerned that a change of political direction could undermine free trade. However, we should also recognise that we are not in a world of free trade. So, it is entirely possible that in disturbing the current status quo, we actually make progress towards this ideal, rather than regress. Yet given our inbuilt predisposition towards believing that what exists at the moment seems to work, we tend to take the view ‘better the devil we know’. Equally, the political worries that many have over Brexit are perfectly rational. But these do not preclude a positive economic outcome for the UK, even in the shorter term. So I suspect that near-term growth expectations for the UK economy are much too low. And, turning to financial markets, expectations that are biased by non-economic/financial considerations will tend to give rise to opportunities.
Richard Jeffrey was Chief Economist at Cazenove Capital until he retired in January 2018.
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