The economics of uncertainty

The research focus on market uncertainty has been strong since the Great Recession. One of the key themes in finance over the last five years has been Risk-on/Risk-off (RO/RO) trading. There has been a strong focus on the VIXX index as an indicator of counter-cyclical market moves. It is only natural that there has been a deep focus on uncertainty by academic researchers over this period.

Though we knew most of this, the research has re-enforced these key relationships. From all of this work we can conclude a few things about uncertainty:

1. Macro and micro uncertainty increases during a recession.
 - The VIXX index of stock volatility will increase during a recession and will be negatively related to stock market declines.
-  The number of newspaper stories on uncertainty will increase in a recession usually because recession are preceded by large macro shocks.
- The dispersion of macro-forecasts will increase during a recession. Forecasters do not do a good job of forecasting turning points in the economy. They only do well at extrapolating trends.
- On the microeconomics side, there is an increase in dispersion of growth across industries during a recession. When the economy slows, marginal business will deviate from market leaders.
- There is an increase in sales dispersion within industries. It is harder to do business in a recession and poorly managed firms will be more hurt more.
- EM economies have more uncertainty based on divergence of forecasts and other macro measures.

2. Uncertainty leads to a delay in decisions. We can think of most business decisions as real options. If there is more uncertainty about a decision, it pays to delay or not exercise the option to act.

3. Uncertainty is counter-cyclical.
-Wages and income volatility is counter-cylical

4. Risk premia go up when there is more uncertainty. Investors have to be compensated for the uncertainty they face.
- Investors and businesses have ambiguity aversion. When it is hard to even make a forecast or provide good estimates of the extreme in a distribution, investors will avoid making any decision. Just hold cash.

The reasons for increase in EM risk premium

There are four reasons for EM risk premiums declining over the last few years and why they have now been rising even with the current improvement in EM equity markets. These are the factors that should be watched.

The four reasons that have driven the EM risk premia are:

1. The China export/import engine - it created new demand for EM markets and was an offset to the US driver.

2. Low rates in developed countries - the low to negative real rates was a boom for EM markets. Real rates are higher in the developed markets and EM real rates have followed in the same direction.

3. Internal improvement - The budget and current account deficits have been controlled and domestic inflation has been much lower than historical numbers. The recent decline in the fragile five has changed the market view on internal economics. There is more focus on each countries as opposed to the EM in total.

4. Commodity price surge -This was a great driver for EM equities. Since commodity prices have languished equities have followed. 

All of these have been in a state of reversal; consequently, EM risk premiums will continue to be tilted to the upside. 

Fed normalization - the new buzz

The new buzz in monetary policy is Fed normalization. Of course, we still are trying to define it before we implement it. We need to go back to basics.

Four conditions are necessary for the Fed to raise interest rates:

1.Above trend growth - the first quarter numbers were negative
2. Tightening of the labor markets - improvement but not close to what Chairman Yellen wants
3. Rise in inflation - still below 2% with little upside
4. Money velocity stabilization - there has not been any

For each of these conditions the answer is, NO for a Fed increase. It is not on the table.

The real issue is with the comments from NYFed president Dudley. He stated that we may come off the zero interest rate bound before stopping the bond reinvestment programs. The Fed wants to raise rates in order the get some flexibility while still holding a large balance sheet. This suggests that we could see a rate increase sooner than expected earlier. It just means that rates could rise while the Fed holds its current huge balance sheet. This is something that the market should watch closer.

Good and Bad Uncertainty - the new research

Uncertainty has been one of the key research areas since the Great Recession. There are many who view that the high level of uncertainty has been holding back current economic growth.One of the more interesting pieces of research I have come across recently has been on the topic of good and bad uncertainty. See "Good and Bad Uncertainty: Macroeconomic and Financial Implications"  by Gil Segal, Ivan Shaliastovich and Amir Yaron. We always think of uncertainty as a bad thing, but uncertainty can be decomposed into good and bad types base don the semivariance of consumption and production. 

Good uncertainty is technological innovation while bad uncertainty will be negative events like the Lehman failure. The first is good for economic growth while the second is clearly destructive. Both contribute to equity risk premium but have opposite signs for the market price of risk.

There are a lot of assumptions and details with this paper, but the the key concept is important. Uncertainty is a priced risk, but it can have good effects not just bad ones. We should embrace good uncertainty and protect against bad. The hard part is telling which type of uncertainty we face. In most cases, this may seem obvious but even good uncertainty can be disruptive for some companies and therefore has priced risks.