Economic Policy Uncertainty

2017 should be a year with many economic policy uncertainties. This is because major political elections were won by populists such as Brexit and Trump in 2016. The result of this political momentum is sentiment which tends to be against free trade and globalization. The movement is fueled by the opinion the respective countries are headed in the wrong direction and the politicians leading them don’t understand the people’s woes. As you can see below, American Republicans especially have changed their minds, becoming against free trade. This means tariffs will be put in place which will hurt global trade. Usually the Republican party had been more aligned with business interests. Ironically, a businessman (Trump) is leading the charge against these free trade agreements.


It’s tough to determine if this populism trend will continue in 2017. In other words, I’m uncertain if uncertainty will rise further. The chart below is produced by Gavekal Capital. It shows each major country’s economic policy uncertainty index. I’m surprised India is the lowest on the graph because of the uncertainty surrounding demonetization and what Prime Minister Modi will do next. You can look at his policy in two ways. You can propose the concept that if he’s willing to do a surprise demonetization, he may be willing to do other unorthodox policies. You can also think now that Modi’s shock policy has already been implemented, he will focus on normalization and ending government corruption. Not surprisingly, the U.K. was at the top for most of 2016 because of the Brexit. I expect the line on chart to lower as the rhetoric surrounding the U.K. leaving settles down and people realize the impact isn’t as bad as it was once promoted to be.

At the end of the graph, you can see China has now taken the lead because 2017 is a big political year for the country. The 19th National Congress of the Communist Party of China will occur. This happens twice per decade, with the last one being in 2012. In autumn, 11 of the 25-member Politburo will open up. 5 of those 7 openings are within the Politburo Standing Committee which is the top leadership. In terms of policy, the SOE’s large debt still needs to be dealt with. Privatizing them would be a great reform, but it means layoffs would need to take place. Any business which is losing money faces layoffs, but the Chinese government doesn’t want to take the pain. The final reason for the uncertainty in China is over how Trump will treat the country. He took a call from Taiwan’s leadership in which they congratulated him on his victory. This was the first call a U.S. president took from Taiwan in 30 years which signals a potential change in the U.S.-China relationship. Trump also criticized China’s South China Sea activity in his press conference Wednesday.


In the past, uncertainty caused markets to be volatile. In my experience, the market would rather bad news to come out than to be left in the dark. This is why you see firm’s stocks go down in anticipation of a dividend cut and then pop up when the cut is announced. When clarity occurs, markets rally. The debt ceiling debate of 2011 caused markets to be the most volatile since the financial crisis because investors didn’t know what the solution would be and when it was going to happen. Now we have political uncertainty throughout the world, but volatility is very low. The chart below shows the divergence between policy uncertainty and volatility. This tells me the market is very optimistic about the future which is uncertain. It’s best to be cautious in the face of blind optimism. Clearly good policies can be put in place, but it’s difficult to tell if they will be.


This optimism can be seen in the chart below which shows the historical measurement of small business confidence. The NFIB small business optimism index for December increased the most since 1980. The index reached 105.8 which is the highest since 2004. 50% of small business respondents expect business conditions to improve in the next 6 months compared to only 38% in November. This is the highest rating since 2002. The number of firms projecting higher sales increased to 31% from 11%. 29% expect to increase capex in the next 6 months.


I have laid out the scenario. Economic policy is uncertain and investors and businesses are optimistic that everything will work out swimmingly. What you think the future will bring depends on your viewpoint of economics. When everyone becomes optimistic does that mean the economy is ready to roar? If we trick ourselves into thinking sales will pick up, will they pick up? I don’t think so. If optimism was all the economy needed to grow, then business cycles would never fade. There needs to be facts to back up optimism or else it will reverse. This particular jump is unlike jumps in the past couple of cycles because the NFIB index was driven by sales growth, while in this case it’s being driven by the expectation that regulations will be cut and the government will have a more favorable attitude towards business. As you can see from the chart below, sales growth is non-existent. Optimism without sales growth cannot last.


The jump in the index in 1980 was a response to the ending of a sharp, quick recession. As you can see from the chart of GDP growth, the optimism made sense because annualized GDP growth improved from about -8% in Q2 1980 to about +8% in Q4 1980. I don’t expect to see a similar jump in GDP growth in the next few quarters.



The worst-case scenario would be if the policy uncertainty leads to trade wars which cut into global growth. Normally when bad events occur, they start out somewhat priced in to the market. In this case, the market will be blindsided along with small businesses as they expect GDP growth and earnings to be great in 2017. It does make me question my negativity on the economy given everyone’s excitement, but I remain doubtful 2017 will be a great year for stock returns.

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