Despite some signs that economic fundamentals are improving – including an improving labor market and rising home prices – U.S. businesses and consumers continue to exercise caution, holding back on spending and new investment.
What’s behind this puzzling dilemma? As I write in my new Market Perspectives paper, “The Price of Politics,” I believe that uncertainty over public policy is partly to blame.
Investors today are contending with an unusually unknown environment. Political division in the United States is the highest it has been in the post-World War II period. In Europe, reconciling a fragmented banking system and implementing structural reforms is still a work in progress. Elsewhere, many emerging markets are struggling with politically contentious reforms and have key elections this year.
The level of political uncertainty is difficult to measure, but there is one measure that can help quantify it: The Economic Policy Uncertainty Index (EPUI) constructed by a team of economists from Stanford and the University of Chicago. According to this index, while policy uncertainty fluctuates over time, it has, on average, been much higher over the past five years.
Historically, higher levels of uncertainty over policy and the political environment have been associated with lower levels of economic activity. The mechanism via which this occurs seems to be the impact of lower business and consumer confidence on spending and investment.
In the past, high levels of uncertainty over policy and the political environment have undermined both business and consumer confidence. For instance, historically, every one point rise in the EPUI has been associated with a 0.1 drop in business confidence. Meanwhile, political uncertainty and consumer confidence have a similarly strong relationship.
So what does this mean for investors? Political gridlock and uncertainty tend to unnerve investors and lead to higher levels of market volatility. This phenomenon didn’t happen in 2013, when volatility remained muted, partly thanks to massive central bank liquidity.
However, this year, the Federal Reserve is tapering at the same time that political uncertainty is likely to remain high. While the December budget accord removed one market risk, there are other policy-related sources of uncertainty that will likely crop up soon, dampening business and consumer spending, and increasing market volatility in the process. You can read more of these unresolved political issues in my full Market Perspectives paper. The bottom line for investors: Prepare for a rocky road ahead.
Source: February 2014 Market Perspectives, The Price of Politics