Market Matters

Policy Flux: How Uncertainty is Shaping Markets and Confidence

By Di Wang

Markets can tolerate risk, but they struggle with uncertainty - and today's environment is brimming with it. From shifting trade policies to unpredictable fiscal decisions, economic policy uncertainty has become a defining trait of the investment landscape. Over recent months, the US Economic Policy Uncertainty (EPU) Index has steadily increased, surpassing pre-pandemic levels and its long-term average (Figure 1A). Unlike cyclical downturns, policy-driven volatility is difficult to quantify and even harder to hedge against.

For asset allocators, understanding the dynamics of economic policy uncertainty is critical. Careful interpretation of policy drivers can help in constructing portfolios that withstand policy-driven shocks while capturing potential alpha opportunities. Navigating today's uncertain climate demands a forward-looking strategy that separates reactive investors from proactive ones who stay ahead of the curve.

 

The Trump Administration and Elevated Uncertainty

Economic policy uncertainty spiked under both Trump administrations, fueled by abrupt shifts in trade and fiscal policies (Figure 1B). For instance, February 2025 saw trade policy uncertainty reach a staggering 2446 - more than 17 times its long-term average of 136. These policies extend beyond the headlines, reshaping market expectations and influencing key economic factors such as inflation forecasts and subsequently the Federal Reserve's (Fed) interest rate trajectory. The interplay of trade and fiscal policy decisions also contributes to rising uncertainty surrounding monetary policy decisions.

Figure 1A: Economic Policy Uncertainty Surpasses Pre-Pandemic & Long-Term Average

zoom_in
Source: Bloomberg. Data from Jan 01, 2015 – Feb 28, 2025.
close
Source: Bloomberg. Data from Jan 01, 2015 – Feb 28, 2025.

Figure 1B: Economic Policy Uncertainty Spikes across All Metrics

zoom_in
Source: Bloomberg. Data from Jan 2015 – Feb 2025.
close
Source: Bloomberg. Data from Jan 2015 – Feb 2025.

Trade Policy Uncertainty

The Trump administration frequently wielded tariffs as bargaining tools, particularly in trade disputes with China and during negotiations with Canada and Mexico. The resultant policy decisions can be both abrupt and unpredictable. From a game-theory perspective, unpredictability can be a strategic advantage, keeping trade partners off balance and potentially securing more favorable terms. However, the outcomes depend on trade partners' responses, creating persistent uncertainty. The impact extends beyond negotiations, affecting supply chains, pricing, and corporate margins, and muddying long-term economic visibility for investors.

 

Fiscal Policy Uncertainty

The Trump administration inherited a national debt exceeding $36 trillion, raising concerns about long-term fiscal sustainability. Investors fear that rising debt levels could undermine confidence in US sovereign debt and the dollar's status as the world's reserve currency. Fiscal policy uncertainty stems from a mix of proposed tax cuts, government spending reductions, and tariff revenues. If tax breaks are enacted without corresponding spending cuts, deficits could rise, pressuring bond markets and potentially inflating risk premiums on US debt.

 

Monetary Policy Uncertainty

Trade and fiscal policy uncertainty also complicate the Fed's decision-making. If tariffs push inflation higher, the Fed may be forced to raise interest rates. But abrupt policy shifts could lead to overcorrections or delayed responses. Add fiscal deficits into the mix, and the Fed's monetary outlook becomes even harder to predict, piling on uncertainty for investors trying to anticipate market movements.

 

Business Confidence Under Pressure

Despite elevated uncertainty, business confidence has remained resilient - even elevated - in recent months (Figure 2A). The key question now is whether this optimism can be sustained as policy uncertainty intensifies, or if rising uncertainty will eventually weigh on corporate sentiment and investment decisions. However, rising uncertainty has begun to weigh on consumer confidence (Figure 2B)2, posing the question of how long this business optimism can last. Extensive research, such as studies by economist Nicolas Bloom of Stanford University, consistently link heightened uncertainty to economic slowdowns. Bloom's research shows that heightened uncertainty leads firms to delay investment and hiring decisions as they wait for clearer policy signals before committing capital3.

Figure 2A: Business Confidence Remains Resilient

zoom_in
Source: FRED. Data from Jan 2023 – Jan 2025.
close
Source: FRED. Data from Jan 2023 – Jan 2025.

Figure 2B: While Consumer Confidence Declines

zoom_in
Source: The Confidence Board/Haver Analytics. Data from Jan 2023 – Feb 2025. Note: Both series are seasonally adjusted.
close
Source: The Confidence Board/Haver Analytics. Data from Jan 2023 – Feb 2025. Note: Both series are seasonally adjusted.

What's more, the economic effects of uncertainty are asymmetrical. Sudden, large spikes in uncertainty tend to create sharper downturns in investment, hiring, and growth than equivalent reductions in uncertainty have on stimulating economic activity4. This cautious reaction to rising uncertainty - with businesses freezing decisions and hoarding cash - tends to linger, prolonging the impact even as policy clarity improves. For investors, this asymmetry can lead to increased risk premiums, flight-to-safety behavior, and greater market volatility during periods of heightened uncertainty, leading to sharper and more volatile market drawdowns. In contrast, market recoveries are often slower and more gradual.

 

Investment Strategies for Uncertain Times

Periods of economic policy uncertainty can have lasting effects on business confidence and market volatility. History and research show that slowdowns driven by uncertainty can be sticky, making it crucial for investors to remain agile and adopt strategies that address potential risks without compromising opportunities.

To navigate today's environment of rising economic policy uncertainty, investors may consider incorporating a portable alpha overlay strategy, which can enhance diversification and generate additive returns without changing underlying portfolio allocations and/or existing active managers. Option-based strategies, such as buffered ETFs, can provide investors protection from downside risks while maintaining upside exposure. Navigating these uncertain times comes down to staying informed, maintaining portfolio flexibility, and preparing for volatility to weather the challenges ahead.

1The categorical data include news-based sub-indexes that require different terms sets. For example, the trade policy category contains terms like import tariffs, government subsidies, and trade treaties. The fiscal policy category contains terms like government spending, federal budget, and fiscal stimulus. The monetary policy category contains terms like federal reserve, money supply, and interest rates. For the complete terms sets and more details on methodology, see https://www.policyuncertainty.com/categorical_epu.html. Each categorical series is normalized to have a mean of 100 from 1985-2010. The long-term averages are calculated using Jan 1985 - Feb 2025 data (EPU 107, Monetary Policy Uncertainty 97, Fiscal Policy Uncertainty 110, Trade Policy Uncertainty 136). The grey bar denotes the recession dated by NBER.

2 Choudhry, T., & Wohar, M. (2024). What drives US consumer confidence? The asymmetric effects of economic uncertainty. International Journal of Finance & Economics, 29(4), 4268-4285.

3 Bloom, N. (2009). The impact of uncertainty shocks. Econometrica, 77(3), 623-685.
Bloom, N. (2014). Fluctuations in uncertainty. Journal of Economic Perspectives, 28(2), 153-176.
Bloom, N., Floetotto, M., Jaimovich, N., Saporta‐Eksten, I., & Terry, S. J. (2018). Really uncertain business cycles. Econometrica, 86(3), 1031-1065.

4 Foerster, A. (2014). The asymmetric effects of uncertainty. Economic Review, 99, 5-26.
Guenich, H., Hamdi, K., & Chouaibi, N. (2022). Asymmetric response of Investor sentiment to Economic Policy Uncertainty, interest rates and oil price uncertainty: Evidence from OECD countries. Cogent Economics & Finance, 10(1), 2151113

References

Di Wang