Ignoring the Reality of Economic Policy Uncertainty

While the stock market is on a tear and there seems to be nothing that will interrupt its rise to the stratosphere, an interesting measure shows that the market is definitely in uncharted territory.

Three professors, Scott Baker from Northwestern University, Nick Bloom from Stanford and Steven Davis from the University of Chicago, have developed an index called the Economic Policy Uncertainty Index (EPU) which has a very unique basis; it is based on an analysis of news items, both past and present.

As we know, since the near-global financial meltdown, concerns about monetary, fiscal and regulatory policies have come to the forefront, particularly since it has become apparent that these policies created the crisis in the first place and have been relatively ineffective at creating pre-Great Recession levels of economic growth and stability.  To look at the role of policy uncertainty, the authors created the Economic Policy Uncertainty Index (EPU) by looking at the 10 leading newspapers in the United States going back to 1985 (the LA Times, USA Today, Chicago Tribune, Washington Post, Boston Globe, Wall Street Journal, Miami Herald, Dallas Morning News, Houston Chronicle, San Francisco Chronicle and New York Times) that contain the following "triple"; "economic" or "economy", "uncertain" or "uncertainty" and one or more of the following; "congress", "deficit", "Federal Reserve", "legislation", "regulation" or "White House".  Here is a graph showing the results:

You can see that the EPU spikes during each crisis over the past three decades including Black Monday in 1987, the first Gulf War, the Long Term Capital Management Crisis, the uncertainty of the 2000 election, September 11, 2001, the Gulf War, the Wall Street/Lehman/TARP crisis etcetera.  This is not terribly surprising but it shows a very close relationship between crises and the use of certain words in the media.

The authors then pushed their examination back in time to 1900, using six major United States newspapers (the LA Times, Chicago Tribune, Boston Globe, Wall Street Journal, New York Times and Washington Post) which shows the following with key events highlighted:

You will also note that there is an upward drift of the EPU over the past century which the authors attribute to the growing role of the government in the economy and the growing level of political polarization in the United States.

The authors used a similar method to create EPU indices for eleven other G10 economies including Australia, Brazil, Canada, Chile, China, Europe, France, Germany, India, Ireland, Italy, Japan, Korea, Netherlands, Russia, Spain and the United Kingdom along with a global index, some of which are shown here:  

  

1.) The United States:

2.) The United Kingdom which clearly shows the impact of Brexit:

3.) Europe:

4.) China:

When combined, this is what the global monthly EPU chart looks like when calculated using a GDP-weighted average of monthly EPU index values for the 17 nations that comprise two-thirds of the global GDP:

It certainly appears that the stock market, in particular those in the United States, is not reflecting any sense of the elevated levels of monetary, fiscal and regulatory uncertainties that exist in the "real world".  With the world's economy so interconnected, the record levels of the EPU index should cause investors to ponder whether now is the time to jump into the market or whether one should wait until the policy dust settles.