As we enter 2025, the financial markets are presenting a peculiar dissonance. On one side, we have equity markets near all-time highs, buoyed by expectations of lower interest rates and a soft landing. On the other, we have a rapidly escalating Economic Policy Uncertainty (EPU) index, painting a starkly different picture of the road ahead. This divergence is not just unusual; it’s a clarion call for investors to brace for impact.
The EPU index, a critical tool for forward-looking investors, has surged to levels not seen since the pandemic’s onset. This spike is largely attributed to the uncertainty surrounding “Trump 2.0” – the potential policies of a second Trump administration. While markets often climb a wall of worry, this wall looks more like a cliff.
Political Uncertainty: The EPUCTRAD-VIX® Connection
The EPUCTRAD Index [1], designed to track trade policy uncertainty, serves as a reliable compass for market sentiment. By analyzing news coverage and policy shifts, it reflects the rising anxiety about economic policies. In recent months, this index has reached levels last seen during the pandemic’s peak uncertainty.
As illustrated in the chart below [2], the EPUCTRAD Index often foreshadows spikes in the VIX. Consider the 2019 U.S.-China trade war: the EPUCTRAD shot up, followed by a volatile VIX. The same happened in 2020 during the pandemic-driven economic shutdown:
Today, the scenario is eerily familiar. The renewed political landscape under Trump’s administration brings with it contentious trade policies, unpredictable regulations, and global tensions—all of which feed into rising uncertainty. This isn’t just a headline risk; it’s a tangible shift in market dynamics.
History teaches us that the EPU is not merely a reflection of current anxieties but a harbinger of future market volatility. Time and again, we’ve observed that a rising EPU precedes an uptick in the CBOE Volatility Index (VIX), often referred to as the “fear gauge” of the stock market. The relationship is clear: as policy uncertainty grows, so does market volatility – and with it, the potential for significant market corrections.
What’s particularly alarming about the current situation is the magnitude of the EPU increase. We’re seeing levels that eclipse those observed during the initial stages of the COVID-19 pandemic. This suggests that the market has yet to fully price in the potential ramifications of a second Trump term.
Market Corrections: Why VIX Spikes Signal a Near End
Bear markets are as much about psychology as they are about economics. Selling into a declining market is emotionally taxing and financially challenging. Historically, VIX spikes align with the final stages of a correction.
So far, we’ve yet to see a definitive VIX spike in the current correction cycle, signaling that markets may not have reached their bottom [2]:
From 1990 to 2022, the data shows a consistent pattern: the VIX doesn’t just predict corrections; it tends to culminate them. For investors, this means that the absence of a spike to ~50, suggests that more turbulence could be on the horizon. When the VIX eventually surges, it’s often the emotional and financial apex of market distress.
The implications for investors are profound. While the VIX currently hovers around relatively benign levels, history suggests this calm is likely to be short-lived. This dislocation between the soaring EPU and the subdued VIX is reminiscent of a coiled spring – the tension is building, and when it releases, the move could be swift and severe.
It’s crucial to understand that elevated volatility isn’t just about increased price swings; it typically correlates with lower equity prices. As uncertainty grows, risk premiums expand, leading investors to demand higher returns for the same assets. This, in turn, puts downward pressure on valuations.
Moreover, the sectors most vulnerable to policy shifts – healthcare, energy, and international trade-dependent industries – could see outsized impacts. The potential for sweeping regulatory changes, shifts in trade policies, and alterations to healthcare legislation under a second Trump administration creates a minefield of uncertainties for these sectors.
For those arguing that the market has already priced in a Trump victory, I would caution against such complacency. The current EPU levels suggest that we’ve only begun to scratch the surface of potential policy-induced volatility. The full spectrum of possible Trump policies – from tariff escalations to immigration crackdowns – has yet to be fully digested by the market.
Navigating the Road Ahead
So, what’s an investor to do in the face of this looming volatility storm? First and foremost, reassess your portfolio’s risk exposure. This is not the time for complacency or over-concentration. Diversification, both across and within asset classes, becomes even more critical in times of heightened uncertainty.
Consider increasing allocations to assets that historically perform well during volatile periods. Gold, for instance, often serves as a safe haven during market turbulence. Ultra short-term investment grade credit could also prove valuable, offering a balance of yield and relative stability in uncertain times.
For the more tactically inclined, the current situation presents opportunities in the volatility market itself. With the VIX at relatively subdued levels despite the surging EPU, strategies that benefit from an increase in implied volatility could be particularly attractive.
There is a clear warning sign that market volatility is likely to increase, potentially significantly. We’re not just facing a bump in the road; we’re looking at a seismic shift in the market landscape. The current disconnect between the EPU and VIX is unsustainable. As the reality of policy uncertainty sets in, we can expect the VIX to play catch-up, bringing with it the potential for substantial market declines. Investors who heed this warning and position themselves accordingly will be better prepared to weather the storm and potentially capitalize on the opportunities that volatility inevitably creates.
Remember, in the world of investing, forewarned is forearmed. We believe the EPU is sending a clear signal – something wicked this way comes. It’s time to batten down the hatches and prepare for turbulence ahead.
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