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All asset classes have exhibited extreme volatility post the financial crisis. Problems in the banking sector, sovereign debt crisis, sluggish growth and economic policy uncertainties have been the major reasons for the volatility.

With significant government intervention in the free markets, economic growth, private sector investments and employment conditions are a function of policies and uncertainties related to that.

In other words, higher the economic policy uncertainty, the greater is the probability of weak economic growth and volatile asset markets.

In trying to investigate the impact of economic policy uncertainties on growth and markets, Scott R. Baker, Nick Bloom and Steven J. Davis came up with an excellent research paper - Measuring Economic Policy Uncertainty.

In this article, I take inputs from the research in order to conclude that global asset markets will remain highly volatile in the foreseeable future. In line with this conclusion, investment options are discussed.

I will first bring forward the economic policy uncertainty index discussed in the research paper and the impact of policy uncertainty on equity markets. Post this, the discussion will relate to the reasons for believing that economic uncertainty will remain high.

According to the paper, the economic uncertainty index is constructed from the following components -

We build the index from components that measure three aspects of economic policy uncertainty: (i) the frequency of references to economic uncertainty and policy in a set of 10 leading newspapers; (ii) the number of federal tax code provisions set to expire in future years; and (iii) the extent of disagreement among economic forecasters over future federal government purchases and the future CPI price level.

The index therefore created does spike in times of economic and policy making uncertainty. This underscores the authenticity of the index -

The resulting index of policy-related uncertainty looks sensible, with spikes around consequential presidential elections and major political shocks like the Gulf Wars and 9/11. Recently, it rose to historic highs after the Lehman bankruptcy and TARP legislation, the 2010 midterm elections, the Eurozone crisis and the U.S. debt-ceiling dispute.

The following charts give the economic policy uncertainty index (calculated monthly) for US and Europe.

US economic policy uncertainty index
(Click to enlarge)

European Economic policy uncertainty index
(Click to enlarge)

Economic policy uncertainty is currently at elevated levels for US and Europe.

The failure of eurozone policymakers to exhibit higher political unity and to implement growth reviving measures is reflected in the index.

With elections round the corner for the United States and uncertainty related to QE, tax reforms and implementation of growth sustaining measures, the index has been trending higher.

The index for U.S. and Europe is well above the historical average indicating a high level of uncertainty among policymakers, which is bound to impact growth.

I will however shift focus to impact of policy uncertainty on equity markets. The chart below gives the determinants of large stock market swings (movement in the S&P index greater than 2.5%, up or down).

Frequency of large moves in S&P 500 index
(Click to enlarge)

Clearly, the equity market volatility has increased significantly in the recent past. The policy related increases and decreases in the market have been noteworthy. Therefore, there is no doubt that economic policy uncertainty has been one of the major causes of asset market volatility.

The discussion has however been focused on the events of the past. It is therefore important to analyze the future course of policy action. This might help in determining the extent of volatility in asset markets in the foreseeable future.

I am of the opinion that -

The U.S. will witness a prolonged period of sluggish economic growth due to consumer deleveraging, weak job market and government action targeting consumption more than capital investment.

The eurozone will also witness a prolonged period of sluggish economic growth due to the sovereign debt crisis, over leveraged consumers and a weak job market.

Geopolitical tensions around the world will remain high and will impact economies and government decisions.

All these factors point towards continued economic policy uncertainties. I might add that we are witnessing a vicious circle of economic policy uncertainties impacting growth and vice verse.

When economic activity remains weak, market participants wait in anticipation of further stimulus from policymakers. The extent of stimulus boosts the markets and a subsequent slowdown due to waning impact of stimulus leads to bearish sentiments. In an economy, which is being propped up by government spending, the time lag between the events mentioned is not significant. As such, volatility ensues.

Therefore, equity markets and other asset classes will experience high volatility in the medium-term. A broad investment strategy for investors would be to ignore short-term market fluctuations, avoid trading and focus on long-term fundamentals.

At times, the focus is so much on macroeconomic events that bottom-up investing is ignored. I would personally look at buying companies with good cash flows and strong industry fundamentals.

Investment Options -

In general, I remain bullish on the U.S. private sector. With a global diversification, corporate profits will remain relatively robust and this will reflect in stock price appreciation for listed entities over the long-term. I would therefore consider buying the SPDR S&P 500 Trust ETF (SPY), which would give me exposure to companies in the S&P 500 index.

In highly volatile markets, I would also consider exposure to low beta stocks. Procter & Gamble Co. (PG) and Johnson & Johnson (JNJ) look attractive with a low beta of 0.27 and 0.48 respectively. Further, these companies are relatively less prone to the impact of economic uncertainty as they cater to the fast moving consumer goods market. These two entities are also dividend aristocrats with 25 consecutive years of increased cash payments.

I am also bullish on commodity stocks. However, the exposure to commodities needs to be long-term and investors can witness short-term fluctuations of 15-20% (either way) in stock prices due to a very high beta coefficient. Some interesting stock picks in the commodity space would be BP Plc (BP) and Total SA (TOT). Both these stocks are trading at an attractive PE along with a high dividend yield. More importantly, rich and diversified oil and gas assets make these stocks attractive from a long-term perspective.

Conclusion -

Volatility is one of the features of the new investment environment. The key, in my opinion, is not to be lost in too much of news and short-term economic factors. Value investing still remains the best way to make money in the markets.

Source: Expect Volatility In Asset Markets With High Economic Policy Uncertainty