Uncertainty: Impact on Economy and Financial Markets
Intuitively, we all understand the concept of “uncertainty” and that it affects decision making for individuals, and that collectively it impacts the economy and financial markets. However, ‘Uncertainty’ is not just a nebulous concept. It is identifiable as Economic Policy Uncertainty or Political Uncertainty, or a combined measure of Uncertainty. Uncertainty is measurable for the U.S and globally (GDP weighted measure), and its impact on the economy and financial markets has been analyzed. Published empirical research by leading institutions like the Federal Reserve Bank shows that Global uncertainty shocks are associated with a sharp decline in global industrial production and global inflation after six months and the maximum decline in global interest rate occurs after 16 months after a global uncertainty shock. Uncertainty tends to reduce the impact of stimulus policy, and is an impediment to a rapid recovery. My own analysis shows that since 2014, U.S and global uncertainty has diverged more than the historical norm, and while U.S equity indices like S&P 500 are recognized to have a substantial international exposure, the VIX is more correlated with U.S uncertainty than global uncertainty. Uncertainty also has predictive power on VIX, one of the most followed financial indicators of volatility in financial markets, in the subsequent one-two months.