The dawn of a new presidential administration often brings economic policy uncertainty, impacting investment portfolios. Hyperloop Capital Insights delves into this dynamic, examining the relationship between economic policy uncertainty and investment returns. Leveraging historical data and the Economic Policy Uncertainty Index, we aim to provide insights for navigating uncertain market conditions.
Table Content:
Analyzing 40 years of stock and fixed-income mutual fund returns alongside the Economic Policy Uncertainty Index, a metric employed by the Federal Reserve, reveals a clear correlation. Generally, stocks flourish when economic policy uncertainty diminishes, while bonds thrive when it escalates. However, certain market segments exhibit greater vulnerability, particularly during periods of heightened uncertainty, such as a presidential transition.
Methodology: Unveiling the Correlation
To investigate this relationship, we analyzed mutual fund return data across diverse asset classes: U.S. large-cap, U.S. growth, U.S. value, U.S. small-cap, international stocks, U.S. fixed income, short-term debt, high-yield debt, international bonds, emerging-market debt, and commodities. Returns were then categorized based on high uncertainty (75th percentile or higher) and low uncertainty (25th percentile or lower). Currently, the economic policy uncertainty environment is high.
Findings: Navigating the Uncertainty Landscape
Our analysis reveals that high economic policy uncertainty generally signals a challenging environment for stocks. For example, the median monthly return for U.S. large-caps is 1.42% when uncertainty is high, compared to 1.52% when it’s low. While seemingly minor, this 0.10 percentage point monthly difference translates to a significant 1.2 percentage points annually.
Riskier asset classes display even greater divergence. U.S. small-caps experience a median monthly return of 1.52% under high uncertainty, contrasting with 1.83% under low uncertainty. This 0.31 percentage point monthly difference equates to almost 4 percentage points annually.
Market Reactions to Uncertainty Shifts
Examining market behavior during substantial shifts in policy uncertainty reveals more pronounced effects. When uncertainty surges (a one standard deviation increase in a month), the median return for U.S. large-caps is -2.01%. Conversely, when uncertainty declines (a one standard deviation decrease), the median return is 1.85%, a stark difference of 3.86 percentage points monthly.
This effect is amplified for riskier stocks. A surge in uncertainty leads to a median monthly return of -1.95% for U.S. small-caps, whereas a decrease results in a 3.56% return, a striking 5.51 percentage point monthly difference.
Fixed-income funds exhibit the opposite pattern, acting as a safe haven during uncertainty spikes. U.S. fixed-income funds yield a median monthly return of 0.63% when uncertainty rises sharply, compared to 0.18% when it falls, a difference of 0.45 percentage points monthly.
Conclusion: Strategic Investment Decisions in Uncertain Times
The current high economic policy uncertainty suggests favoring short-term bonds over stocks. However, if uncertainty diminishes, stocks, particularly small-caps, become more attractive. Monitoring the Economic Policy Uncertainty Index and understanding its impact on various asset classes are crucial for informed investment decisions. Hyperloop Capital Insights will continue to provide in-depth analysis to navigate the complexities of the financial markets.
