Can uncertainty cause a recession?
Economists are always looking for ways to test their theories. They can’t put economies into test tubes and sprinkle a little stimulus on them—they have to look for natural ways to examine how people react economically to new conditions. So they study businesses right near a state border to see if changing the minimum wage law has much impact, or they use the draft lottery to study the effect of military service on lifetime earnings.
The Brexit vote offers another such opportunity. One of the key arguments that the “Remain” camp used in the run-up to the vote was that the economic uncertainty that would be triggered by a “Leave” vote would cause a recession in the UK. But right now it looks like Britain is weathering the storm just fine, thanks. A manufacturing index recently jumped to its highest level in more than two years, and a Citigroup index tracking economic surprises is nearing a three-year high. Far from slouching towards a recession, the London stock market seems to be forecasting better times ahead.
FTSE 350, before and after Brexit vote. Source: Bloomberg
The Brexit vote should provide a good test of the “uncertainty theory” of business cycles. That is, if businesses think the outlook is unclear, they may pull in their horns, delay hiring or investing, and this could propagate through the economy, causing a general downturn. Or uncertainly may have little effect. Well, this vote has created a massive amount of uncertainty. While the policies resulting from UK leaving the EU won’t be in place for several years, the uncertainty is present now. Economists who subscribe to this theory think that Brexit will cause a recession. This test is almost ideal.
The real effects of Britain exiting the EU have yet to be determined. Britain still hasn’t given official notice under Article 50 of the Treaty on European Union that they intend to leave, although that’s been promised. The full process is likely to be complex and intricate. But the impact of the Brexit vote itself ought to be known pretty well over the next 4 to 8 months. By then we may be able to decide whether confidence is a significant economic input, or if “uncertainty theories” can be tossed into the dustbin of failed economic speculations.
Douglas R. Tengdin, CFA
Chief Investment Officer