Presidential transition brings policy uncertainty
As a new presidential administration takes office later this month, there’s been a lot of discussion about potential changes to various policies, from taxation to trade to regulation, creating some “policy uncertainty.”
Of course, this kind of uncertainty when there is a change of government is nothing new—nor is it unique to the United States. That’s why economists build indexes to track policy uncertainty around the world, often incorporating the number of news articles mentioning different policy uncertainties.
The uncertainty index can track a broad subset of economic policy or trade policy, etc.
Several types of these indices are particularly relevant right now—broad economic policy uncertainty and narrow trade policy uncertainty.
Going back to 1990, economic policy uncertainty (chart below, blue line) has been the more volatile of the two, typically rising during recessions (grey shaded area) and falling during expansions (white area). Currently, it remains close to the historical average (the zero line) – just as it was during President Trump’s first term (until the pandemic recession).
However, trade policy uncertainty (purple line) fluctuated relatively modestly from 1990 through the first Trump administration, with trade policy uncertainty increasing as President Trump reintroduced tariffs. Since the most recent election, we have seen trade policy uncertainty return to levels last seen during President Trump’s first term.
History shows markets respond to economic policy uncertainty but not trade policy uncertainty
Since there’s an old saying on Wall Street that “markets hate uncertainty,” you might think that increased trade policy uncertainty would be bad for markets.
However, when you overlay the VIX stock volatility indicator (chart below, orange line) with trading policy uncertainty, you see that there is no real relationship between the two.
When trade policy uncertainty hit record highs in 2018 and 2019, the VIX typically remained at the following The average since 1990 (shown as a negative number in the chart). Not to mention that both the S&P 500 and Nasdaq 100 have hit 10 new highs since Election Day.
But the chart does show the market hates it economic policy uncertain.
When we see a sharp rise in economic policy uncertainty, we also see a sharp rise in the Volatility Index (VIX). When we see above-average economic policy uncertainty (positive numbers), we typically also see above-average VIX readings (positive numbers).
Of course, these peaks and above-average readings are closely correlated with recessions, which naturally creates uncertainty about how economic policy should respond (especially since the past two recessions were historically bad) and drives market selloffs.
Reduced scope of trade policy limits its impact on markets
This is the main difference between economic policy and trade policy. Economic policy is broad, while trade policy is narrow, making it less important to the overall health of the economy.
Therefore, if history is a guide, when uncertainty is limited to trade policy, the impact on the market is often limited.
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