The Dow has been swinging hard lately. The widely watched industrial average fell by more than 350 points for three consecutive days to end last week, then dropped 653 points on Monday. It was closed Tuesday. Wednesday, it was back up 1,086 points.
President Trump, who famously used unpredictability in his career as a real estate developer and self-proclaimed dealmaker, probably did not want to apply that word to his effect on the stock market. For much of his tenure, he has taken credit for stock market gains.
But by multiple measures, the market’s future seems less certain now than at any time since Trump’s election. It’s hard to know how much can be directly tied to him. The market has been climbing for a long time, and the Federal Reserve’s interest rate hikes, while expected, may be muddying the outlook. It’s hard to conclude, though, that Trump, with his trade war, White House crises and criticism of the Fed, is a force for certainty.
And a large body of economic research shows that the type of uncertainty that worked for one business executive won’t do the same for the economy at large.
When the future is uncertain, businesses tend to hire less and invest less in the equipment, people and innovations that become the foundation for long-term economic growth.
We can measure uncertainty in several ways. One of the most common is a market-derived measure known as a volatility index, a popular version of which uses options for the Standard & Poor’s 500 to estimate how much that index will swing over a 30-day period or so. We can use the same technique to measure investors’ expectations of S&P 500 volatility over the next six months or year.
As you see in the chart below, the measure is projecting that the S&P will continue to swing wildly in the next 30 days and maintain a high level of volatility well into next year. (Although the chart does not show 2019 explicitly, it is based on current market expectations of future events.)
We’re focusing on the longer-term measures, rather than the widely watched short-term volatility index. A rise in expected volatility over that longer run is more strongly associated with slowing business investment, especially in research and development, according to a recent National Bureau of Economic Research working paper by Stanford University PhD candidate Jose Maria Barrero, Stanford economist Nick Bloom and Ian Wright of Goldman Sachs. (Wright contributed as a private individual and not as a representative of the investment bank.)
Barrero and his collaborators found that uncertainty about government policy tended to coincide with a rise in longer-term uncertainty. Volatility in interest rates and currency prices showed the same tendency. Changes in corporate leadership and volatility in oil prices did not.
The Treasury yield curve, most commonly simplified as the gap between yields on three-month bills and 10-year notes, helps capture investor expectations of economic growth. Usually there’s a sizable gap between short-term bonds, which pay little interest, and long-term bonds, which pay more interest, because investors generally have more confidence in the long term than the short term.
That gap has closed rapidly since October. It’s closer to inverting than it has been at any point since before the Great Recession, which implies that investors are losing faith that things will keep getting better. In the past 60 year or so, recessions have arrived between five (1959) and 17 (2006) months after a yield curve has inverted, with one exception (1966).
Another widely cited measure, the Economic Policy Uncertainty Index, analyzes major newspapers (including The Washington Post), economic forecasts and the tax code to create a single measure of the uncertainty caused by government policy. The academics behind the measure, a group that also includes Stanford’s Bloom, have found a strong relationship between rising uncertainty and slowdowns in economic growth and hiring.
According to that index, the seven days ending Dec. 26 marked the most uncertain seven-day period for the United States since the week of the 2016 presidential election and the third most uncertain in the past five years (not counting those seven-day periods that might overlap).
The index has found a more uncertain policy climate under Trump than during President Barack Obama’s second term, on average. Yet for more than a year, Commerce Department figures showed decent growth in business investment.
That trend appears to have slowed in the second half of 2018. Business investment grew at an annualized rate of just 0.6 percent between the second and third quarters. Figures for the fourth quarter won’t be released until the end of January, assuming the government shutdown is resolved by then.
Uncertainty could increase. The president’s response to market turmoil could create an unfortunate feedback loop. When stock market indexes fell last week, a drop that was probably exacerbated by fears of an uncertain future, Trump lashed out at the Fed, leading to speculation that he might consider removing both the treasury secretary and the Federal Reserve chair. His senior advisers have since rushed to assure markets that won’t happen.