Mark Barnes, PhD,
Alex Nae, M.Sc
- Divergence in economic policy uncertainty (EPU) between the US and the rest of the world increased, alongside a general increase in EPU from 2000 to 2024.
- Higher EPU did not lead to sustained higher volatility in the Russell 1000 index, but significant EPU increases led to higher short-term volatility.
- Election season in the US led to higher market volatility, followed by volatility returning to normal.
Risk is an ever-present component of financial market analysis. One very specific form of risk that has leapt to the fore recently is economic policy uncertainty (EPU). This differs from economic uncertainty which can be caused by uncertainty over economic shocks that may occur in the future, or by uncertainty over exactly how the economy will evolve due to its complexity. EPU, on the other hand, is driven by uncertainty over what government policies will be operational in the future. As such, EPU can overlay the general uncertainty about future economic shocks.
Economic Policy Uncertainty index
In this insight we highlight an interesting Economic Policy Uncertainty index and analyze the impact of EPU on the historic volatility of the Russell 1000 index.
We use the Economic Policy Uncertainty indicator developed and maintained by three economists (see Baker, Bloom, and Davis, 2016) which attempts to capture the level of EPU using three categories of metrics. The metrics can vary somewhat across time and countries, but for the US they are currently:
- Newspaper coverage: this tracks the volume of articles from 10 major US newspapers related to economic policy uncertainty.
- Federal tax code expiration: this is a measure of federal tax provisions set to expire as reported by the Congressional Budget Office (CBO). A higher number of expiring provisions indicates higher uncertainty regarding tax policies.
- Forecast disagreement: the third variable is derived from the Federal Reserve Bank of Philadelphia Survey of Professional Forecasters. It measures uncertainty by looking at the dispersion in predictions about key economic variables, such as the Consumer Price Index and government expenditures. Dispersion reflects different expectations about future policy impacts.
The data is hosted on the policyuncertainty.com website.
To provide a sense of the movement of the EPU index, exhibit 1 shows the Global and US index for the period since 2000. The Global EPU index is a GDP-weighted average of 21 national EPU indices, including the US. We can see a few instances of jumps in the indices around well-known policy crises. For example, the Global Financial Crisis (GFC) was a shock in itself, but it was not certain how regulators, central bankers, and governments would respond to the crisis, causing a jump in EPU. We see a jump again in 2011 due to the Eurozone debt crisis and perhaps also the leadup to the US election in 2012. Then again in 2016, the unexpected Brexit vote and Trump’s election to the US presidential office led to much higher global EPU. Since then, US EPU dropped back down to its previous level while the global measure remained higher.
The most important jump in EPU was seen when Covid hit and there was uncertainty over how governments around the world would respond to the health and economic crises. After the introduction of Covid vaccines in Jan. 2021, the EPU index dropped quickly, but that shock was soon replaced by the Russian invasion of Ukraine in Feb. 2022 and the global inflation surge that raised global EPU more than that of the US. Since then, the indices have drifted down, although they are still somewhat elevated compared to earlier periods.
Two key changes that stand out over time are that 1) EPU has been higher recently compared to 20 years ago, and 2) global EPU has been higher than in the US. This is likely due to a series of economic policy challenges globally including the European debt crisis, the refugee crisis in Europe that upset political patterns, Brexit, increased protectionism, the Russia-Ukraine conflict, and the global inflation surge.
Exhibit 1. Economic Policy Uncertainty Index, US and Global
Source: Economic Policy Uncertainty and FTSE Russell. Data as of 30 September 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Economic policy uncertainty and equity market volatility
To get an idea of how EPU affects equity market volatility, Exhibit 2 compares the US EPU index with the volatility of the Russell 1000. To obtain a high frequency measure of volatility, we measure it here as the square root of the monthly average of squared returns times 260. The first observation is that the level of the EPU index does not seem to be closely related to equity volatility. For example, while the EPU index did jump at the time of the GFC, the level at that time was much lower than the level during the Brexit / Trump election period, but the equity market volatility was much higher. Furthermore, the recent period of relatively high EPU index levels have been accompanied by relatively low levels of realised volatility.
Exhibit 2. US Economic Policy Uncertainty Index and Russell 1000 Index volatility
Source: Economic Policy Uncertainty and FTSE Russell. Data as of 30 September 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
However, because the jumps in both series seem to be related, we next considered whether changes in EPU are correlated with volatility. In Exhibit 3 we use the difference between the 3-month moving average of EPU and the 12-month moving average to indicate whether the EPU index is generally increasing or decreasing. This measure shows a much stronger relationship to volatility.
Exhibit 3. Change in US Economic Policy Uncertainty Index and Russell 1000 Index volatility (RHS). US elections are shown by orange bars.
Source: Economic Policy Uncertainty and FTSE Russell. Data as of 30 September 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Economic policy uncertainty and the US election cycle
A recent article analyzes the historical performance of equity markets around US elections in terms of both returns and volatility. Here we focus on equity market volatility and relate that to EPU. The orange bars in Exhibit 3 indicate the US elections. We can see that there has generally been an increase in policy uncertainty around the time of the election, followed by a decrease, once economic policy programs become clearer.
Exhibit 4. Average EPU change around US elections, 2000-2020
Source: Economic Policy Uncertainty and FTSE Russell. Data as of 30 September 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Where are we now?
As of the writing of this article, we are a little less than one month away from a very close US presidential election. We have seen that the 3-month / 12-month cross-over has started to rise indicating an increase in EPU (Exhibit 5). While there is naturally some uncertainty related to the uncertain outcome of the election, there may be some additional uncertainty past the election outcome as to how policy will actually be implemented. This may well be accompanied by higher equity market volatility.
Exhibit 5: Change in Economic Policy Uncertainty Index (3m -12m) and Russell 1000 Volatility, last 12-months
Source: Economic Policy Uncertainty index and FTSE Russell/LSEG. Data as of 30 September 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
While there are many sources of uncertainty in financial markets, in this article we have focused on EPU and linked that to equity volatility. In particular, we find that while core EPU levels have increased over the years, this has not been matched by a secular increase in equity volatility. Rather, changes in EPU tend to accompany volatility at key dates such as elections. US EPU has increased since the start of the 2024 US election campaign, and alongside it so too has volatility in the Russell 1000.
References
Cui, Z., Tang, K., & Wang, Z. 2023. Economic policy uncertainty and stock market volatility: The role of investor sentiment. Journal of Banking & Finance, 142, Article 106657.
Baker, S.R., Bloom, N. and Davis, S.J., 2016. Measuring economic policy uncertainty. The Quarterly Journal of Economics, 131(4), pp.1593-1636.
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