How Does Policy Uncertainty Affect Investments?

Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Kate (00:00):
Hello, Veljko.

Veljko (00:01):
Hello, Kateryna.

Kate (00:02):
Today, I would like to start our episode with a question to our listeners.
Have you ever waited to make a decisionon a big investment or a big purchase
just because things were so uncertain?
There was just a lot ofuncertainty in the air, so to say.

Veljko (00:20):
Have you Kate?

Kate (00:22):
Well, I am actually moving from the University of Missouri
to the University of New Mexico.
So I'm starting a newposition in Albuquerque.

Veljko (00:31):
And congratulations, Kateryna, congratulations to you and
congratulations to the Universityof New Mexico for a great hire.

Kate (00:39):
Yes, very excited.
But besides starting a newjob, you have to live somewhere.
You look at housing and so I'vebeen looking at housing, and housing
is a big investment decision.
Actually, there's a lot of uncertaintyin the air now regarding housing and
especially for people in our situation.
What does it mean?
Our situation?
We're both academics and there's a lotof policy uncertainty in the educational

(01:02):
sphere, and we don't really know what'sgoing to happen to student enrollments.

Veljko (01:07):
Let me understand this fully.
The uncertainty you're talkingabout is uncertainty about student
enrollment, federal support foreducation, federal grants, right?
I mean it's government policy that'screating some degree of uncertainty.

Kate (01:22):
You're right.
Government policy.
And another type of uncertainty alsorelated to government tax policy
in this case is there are somediscussions about the changes to
the tax code on the sales of homes.
And as you know, in order to buy a home,one generally needs to sell a home.
So it's uncertain right now whetherwe will be paying taxes, lower

(01:44):
taxes, on the sales of homes or not.
And of course that's goingto influence prices too.
And there's just a lot of uncertaintyon all of these fronts created by
government policies in different spheres.
So renting sounds like a reallygood possibility right now, which
allows one to delay investment inhousing because there is uncertainty.

(02:05):
So that's my personal anecdote.
What about you?

Veljko (02:08):
What about me?
I am buckling the trend, Kate.
In the face of greater uncertainty,I went out and I bought a new car.

Kate (02:16):
Ooh.
Why did you do that?

Veljko (02:18):
I mentioned uncertainty, right?
But, I guess it's interestinghow it can cut either way.
I was expecting car prices to goup, to increase because of tariffs.
It does go back to policy uncertainty.
I was expecting prices to go up andas soon as President Trump announced
new tariffs on Liberation Day, Fordactually announced a big discount plan.

Kate (02:43):
You were attracted by the discount and, but you were also, it sounds like
were a bit worried about the future,possible increase in prices, plus
obviously a good deal with discounts.

Veljko (02:52):
Yeah.
To be honest, by the time the discountscame around and led me to a particular
manufacturer, Ford, I was alreadyinto the market thinking, well, I
gotta buy a car before this uncertaintymaterializes into something bad.

Kate (03:07):
So we were both worried about uncertainty, but it pushed us into
very different decision mechanisms.
I was looking at the housing marketand I've decided to rent and delay
the investment because of a lotof uncertainty happens there.
And partially because I'm thinkinghousing prices might decline

(03:27):
while you decided to buy a car.
While there's lots of uncertaintyin the air with tariffs, but
partially because you were worriedthat prices will go up and because
it was such a great deal right now.
So different decisions,same mechanism in play.
Uncertainty, policy uncertainty.

Veljko (03:44):
It's interesting and apparently paradoxical how one of
us is delaying an economic decision.
The other one is anticipatingit because of the uncertainty.
Goes to show you even peoplewith a PhD can approach these
things very differently.
But, today we want to talk alittle bit more broadly about what
does research say about how onereacts to policy uncertainty.

Kate (04:05):
At the macro scale, about corporate strategy, government
policy, all of these things.
How does it all tie together.
Hiring, a variety of business decisions?
What do firms do?
What does the economy do when there'shigh levels of policy uncertainty?

Veljko (04:21):
And just to put this into the right context, regardless of how you
feel about the current administration,about trade policy, immigration
policy, about the big beautiful billand big changes in fiscal policy, the
one thing that I think we can allagree is that there are strong, big
transformative actions by the government.
That some of these actions are notalways communicated very clearly.

(04:46):
Take tariffs... one day we areadding one day we are subtracting.
So regardless of how you feel aboutthe current politics of the moment,
I think we can all agree thatpolicy uncertainty is very high.
And I think it's important to startthinking about how ultimately
this affects your bottom line.

Kate (05:02):
Our mission is always to give you our listener a shortcut into understanding
the most cutting edge of academic researchin this case, what has it said about
policy and uncertainty and its influenceon firms and markets and your portfolio?
And, we hope that you will walk awayfrom this episode feeling genuinely well

(05:23):
informed, hopefully with some interestingfacts that you didn't know about before.
And we hope that this is gonnawork well for your investment
portfolio and your overall knowledge.

Veljko (05:36):
You have to clean up your sales spiel, Kate.
We want to make everybody a billionaire.

Kate (05:41):
That, that would be, that would be even better.
But before we do, I want to mentionagain that our sources, as always
are influential peer reviewedstudies from top academic journals.

Veljko (05:53):
Absolutely.
What does academic research teach usabout dealing with policy uncertainty?

Kate (06:00):
Let's do it now.

Veljko (06:12):
Welcome to Questions in Finance,

Kate (06:15):
a podcast where we translate academic mumbo jumbo to answer
interesting questions in finance.
I'm Kate Holland.

Veljko (06:23):
And I'm Veljko Fotak.
Kate and I met when we were PhDstudents at the University of Oklahoma.

Kate (06:29):
Today we're university professors and we spend our days
teaching and researching companies,markets, and all things related.

Veljko (06:39):
Okay, Kate.
We generally try tostart with a definition.

Kate (06:45):
Oh, definitions.
That's a good start, but a boring start.

Veljko (06:50):
Sometimes boring things are necessary.
We are gonna focus specifically todayon policy uncertainty and policy
uncertainty as commonly definedin our literature, refers to the
lack of clarity about governmentactions and in our case, actions that

(07:10):
affect the economy in particular.
So we are gonna be, if youwanna be precise, talking about
economic policy uncertainty.

Kate (07:17):
"Economic policy uncertainty" actually is the name of one of
the main indices that's now usedto measure policy uncertainty.
It's called the EPU foreconomic policy uncertainty.

Veljko (07:30):
And this comes from Scott Baker at Northwestern University.
Nicholas Bloom at Stanford,and Steven Davis at Chicago.
And I guess he also has adual affiliation with the
Hoover Institute at Stanford.

Kate (07:45):
So spot on name, " economic policy uncertainty" cannot be more clear.
And so we will keep referringto it as the E-P-U-E-P-U.

Veljko (07:52):
And this index was introduced in a 2016 Quarterly Journal of Economics
article, and the authors have made thedata available for other researchers.
This has become extremely useful andinfluential partially because of that.

Kate (08:06):
Let's talk about how does it work?
How does it work?

Veljko (08:08):
Before we talk about how does it work, how do they
define policy uncertainty?
And in this manuscript, policy uncertaintyrefers to, in their words, "the lack
of clarity about government actionsthat affect the economy." And then they
say, "for example, uncertainty aboutelections, legislation, fiscal policy,
monetary policy, or regulatory decisions."

Kate (08:28):
Very broad.
Considering a lot of categories that onewould associate with policy uncertainty.

Veljko (08:33):
Indeed, it's every government policy that has an impact on the economy
and how uncertain that policy is.
Now, at the time of recording,

Kate (08:42):
Summer '25.

Veljko (08:43):
Absolutely.
And we are in a unique conjunctionin time, as we are gonna see soon.
Economic policy uncertaintyis at sky-high levels.

Kate (08:52):
The

Veljko (08:53):
EPU index
Pretty much every index ofpolicy uncertainty is breaking
new records every day.
So back to our index.
There are three bigcomponents to this index.

Kate (09:04):
I know that one of the components deals with what's
reported in the newspapers.

Veljko (09:10):
Well, they're effectively looking for keywords in news media.
The keywords are thestuff you would expect.
"Economic policyuncertainty" is a keyword.
The innovative side of this indexwas the analysis of news coverage.

Kate (09:24):
This index is picking up and tracking media sentiment.
Which is super fascinating that thatcan be a reliable economic indicator.

Veljko (09:32):
And we might wanna pause just for a moment, to appreciate the fact
that economic policy uncertainty isa very clear concept, and yet it's
also one that's difficult to measure.

Kate (09:44):
Right?
It's a very qualitative ideas that puttingit quantitatively becomes difficult
and this paper has been able to do it.

Veljko (09:51):
Yeah.
Uncertainty has a lotto do with perceptions.
You're trying to measure astate of mind ultimately.
So you do have to get a littlebit creative in how you do that.
And of course, the Baker Bloom Daviesinnovation here is to use news coverage
and to try to use key words that expressdegrees of uncertainty about policy.

(10:11):
Now, they do measure two otherlegs for this index, if you will.
They look at tax code expirations.

Kate (10:19):
I see.

Veljko (10:19):
So they look at how many provisions in the tax code are
due to expire in the near future.

Kate (10:26):
So taxes are very important for businesses and tax regulation obviously
influences how businesses make decisions.

Veljko (10:33):
These expirations of tax code provisions tend to
trigger big political fights.
So there's a lot of uncertainty to whatfiscal policy will be right afterwards.
And then finally you have dispersionof forecasts of professional analysts
and economists, that's a third leg.
Effectively, they look at whatprofessional analysts are saying

(10:56):
about macroeconomic factors.
Stuff like GDP growth stufflike the unemployment rates,
stuff like the housing report.

Kate (11:03):
Important economic indicators and the forecast for them.

Veljko (11:07):
Most of it is as you correctly pointed out, macroeconomic factors.
And the intuition here is thatif there is more disagreement
in the forecasts, it seems toindicate there is more uncertainty.

Kate (11:19):
If me and you guess something is going to be a 10
and a 9.9, that's pretty close.
But if I say something's going to bea five and you say something's going
to be 15, there's a lot of dispersion.
We're not sure where it ends.

Veljko (11:32):
It's really about the extent to which experts agree or disagree.
So you take these three components,whatever you wanna call them.
You give them different weights andthey're giving news coverage here
the largest weight, and you come upwith a numerical score that indicates
how scary, how uncertain things are.

Kate (11:53):
Very clever way to quantify something so qualitative.
But I would like to understandhow does this actually track with
moments where one would expectpolitical uncertainty to be high?
Does this actually work, does this EPUindex spike up and fall down in periods
of high and low political uncertainty?

Veljko (12:12):
Of course.
I can talk about external validity,which is just a fancy way of
saying we test whether thismakes sense in the real world.
And, that's all you cando, at the end of the day.
You start with periods whereyou have reasons to believe that
political uncertainty is high.

Kate (12:27):
Like like what?
Give me some examples.

Veljko (12:29):
For example, in the manuscript, they look at the 9/11 attacks.
They look at the 2003 Iraq invasion.

Kate (12:38):
Okay?

Veljko (12:39):
They look at the collapse of Lehman Brothers in 2008.
They look at the series ofclose US elections, and at
the 2011 debt ceiling crisis.
I know they look at Brexit in 2016.

Kate (12:53):
So all of these periods when we would expect a spike or an increase
in the economic uncertainty...

Veljko (12:57):
indeed, that's exactly the case.
And, just as you wouldexpect, they're finding it.
They're finding that the index picksthis event fairly accurately and seems
to move just as you would expect.
And so there is, if youwill, external validity here.
Ever since this came out,it's become the gold standard.

Kate (13:16):
I think it would be interesting to mention papers that measure some
specific areas of political uncertainty,some of the newcomers and perhaps
some of the predecessors, but ourstar of the show will be the EPU.

Veljko (13:29):
There are really two directions in which this EPU is being
applied, that are researchers thatare applying it at a firm level.
Instead of looking at news coverage,they're looking at earning reports.

Kate (13:42):
You are talking about Tarek Hassan,Stephan Hollander, Laurence van
Lent, and Ahmed Tahoun, 2019 QuarterlyJournal of Economics paper, where
they using earnings calls, which firmsannounce earnings four times a year.
They're using these quarterly earningscalls and doing a word search within
the firm specific earnings calls toidentify firm level political uncertainty.

Veljko (14:07):
What you're really measuring

Kate (14:08):
at that

Veljko (14:09):
point is the firm's sensitivity to political uncertainty.
these are not quite the same.
Political uncertainty is almostby definition a country level...

Kate (14:19):
Yeah.
I can see that at the country level.
Of course, all firms probably hada spike in political uncertainty
around the 2012 debt ceiling.
They still find a lot ofvariation at the firm level.

Veljko (14:30):
And then there is a second direction in which
this literature is going.
And this second direction is insharpening the keyword look at specific
types of policy uncertainty, right?
There is a big literature in bondmarket analysis where they're looking
at monetary policy uncertainty, wherethey're looking at uncertainty about

(14:53):
what the Federal Reserve is doing.

Kate (14:55):
Another similar index that I am thinking about.
There's an index by Marina Azzimontiin a paper published in the Journal
of Monetary Economics in 2018.
She titled it "Partisan Conflict andPrivate Investment." This paper came
out two years after the EPU Index,and she also looks at newspaper
articles, but she looks at a lawmaker'sdisagreement about policy specifically.

(15:19):
So she's sharpening an angleand she called it the PCI,
Partisan Conflict Index.
And the Partisan ConflictIndex is also freely available
online, just like the EPU is.

Veljko (15:31):
That doesn't really sound like a direct measurement
of policy and uncertainty, butI suppose when there's more

Kate (15:36):
partisan

Veljko (15:36):
conflict, there's more uncertainty.
I was thinking of something else.
There is a paper by Marcelo Bianconi,Federico Esposito, and Marco Sammon.
This is in the Journal of InternationalMoney and Finance in 2021, and the
title is "Trade Policy Uncertainty,and Stock Returns." They're creating
an EPU like index that focusesspecifically on trade policy uncertainty.

Kate (16:01):
They're having a fun time this year, I bet.

Veljko (16:03):
They're in high demand.
And the index

Kate (16:05):
is To the

Veljko (16:06):
through the roof as you can imagine.

Kate (16:07):
So we've talked about the star of the show's, EPU.
We've talked about some newcomers thatlook at the firm level and also some
things that drill in more includingthis trade specific index and also
the PCI Partisan Conflict Index.
But what happened before 2016?
How did people think and how didthey measure political uncertainty?

Veljko (16:29):
For the most part, it was elections.
For the most part, they were usingpolitical uncertainty, if you will,
as a proxy for policy uncertainty.

Kate (16:38):
Election periods, especially presidential elections, a period
of possible large changes, whichcould influence policy as well.
I see.
It makes sense.
Great, we figured out how tomeasure this elusive uncertainty.
The next big question is, whathappens to the real economy, what
happens, to how businesses operate?

(17:00):
So what happens in the economywhen political uncertainty is high?

Veljko (17:04):
Political uncertainty for the most part tends to depress corporate activity.
Corporations delay investments.
Especially the big decisions, andthat in turn generates lower growth.
And that in turn has anegative impact on employment.

Kate (17:21):
Firms delay their investment.
They don't start new projects,they don't build new factories.
Again, it's a delay to seehow the policy will settle.
But in the delay period, as youpointed out, that has effects on
growth, employment, and, the economy.
Baker, Bloom, and Davis point out thatthe EPU, higher levels of EPU is related

(17:44):
to lower hiring and weaker economy,at the aggregate economic level.
A different paper that doesn'tlook at the overall economic level.
It drills into firms.
This is Huseyin Gulen and Mihai Ion,my former colleagues from Purdue and
Hussein is still there, and Mihai I thinkis at the University of Oklahoma now.
But in 2016, they published thepaper that used the EPU to see what

(18:10):
happens to corporate investment.

Veljko (18:13):
And what do they find?

Kate (18:14):
First it's also important to clarify what is corporate investment?
So a lot of these papers thatmeasure investment by companies,
usually at the heart of firms' bigdecisions, look at this measure
of CapEx or capital expenditures.
Purchases of new equipment,new factories, et cetera.
And so, when they look at this type ofspending by US companies, they show that

(18:39):
there's a decline in investment wheneverEPU, the Economic Policy Uncertainty index
from Baker Bloom and Davis's paper spikes.

Veljko (18:50):
And I'm looking at my notes, they actually come with
some very precise numbers.
They claim that a doubling of the EPUindex is associated with an 8.7% drop
in average capital expenditures rate.

Kate (19:06):
9% decline.
That is, that's substantial.
9% decline in investment.
That is a lot.
So firms delay a lot of equipmentpurchases, building perhaps
a new building, et cetera.

Veljko (19:20):
And again, the emphasis here being you are delaying the irreversible stuff.
They use this term, theirreversible investment.

Kate (19:27):
The paper points out that industries with more irreversible
investment suffer more.
But can you define what does"irreversible investment" mean?

Veljko (19:35):
What I mean with irreversible is long term.
It's the stuff that has a threethree year horizon plus, right?
So you're not curtailing so muchthe short term expenditures, You are
more worried about if there is policyuncertainty, is this plant going to be
viable 3, 5, 10 years down the road?
If you're not certain, you might hold on.

(19:56):
Which again, is gonna be very relevant towhat is happening right now because some
of the trade policy that we have rightnow wants to push firms to reshore and to
bring manufacturing, if you will, back.
And you can see how the uncertaintyabout these policies is making this

(20:17):
type of long-term capital investmentextremely problematic and difficult.

Kate (20:21):
So this paper had another interesting finding that caught my eye.
They were looking at the2008 financial crisis.

Veljko (20:29):
It caught my eye too, perhaps I was a little bit
skeptical about their bottom line.
But they attribute one thirdof the market collapse in 2008,
2009, to policy and uncertainty.
And to go back 2008, 2009,this is the mortgage crisis.
Lehman has just failed.
US markets were down, Ithink, 54%, the Dow Jones.

Kate (20:53):
That is crazy a third of that is due to policy uncertainty.
Interestingly, two years later, MarinaAzzimonti came out with her PCI index and,
she looks at the aggregate economy whilethis paper by Huseyin Gulen and Mihai Ion
look at the corporate sector specifically.
But Azzimonti also looks atthe 2008 financial crisis

(21:15):
and she finds the following.
She says that 27% of the declinein aggregate US investment during
the 2008 financial crisis is dueto an increase in uncertainty.
So it maps spot on

Veljko (21:30):
you

Kate (21:30):
know, a third, 27% so there's support for that figure.

Veljko (21:35):
Okay.
I'll put my skepticism away in that case.
We were mentioning earlier, we hadresearch on this topic before the EPU.
One paper that's often cited isa paper by Julio and Yook this
is a Journal of Finance in 2012,

Kate (21:51):
Right.

Veljko (21:51):
they're looking at elector uncertainty.

Kate (21:53):
Elections and elections are especially uncertain
outside of the United States.
So this is a global study.
They span over 48countries in their sample.
Not only the United States, butobviously a lot of other countries
with much higher levels of politicaluncertainty and instability where
election years are key and fundamental.

(22:14):
So, what do they find?

Veljko (22:15):
Actually they also have a very clear cut bottom line and they estimate
that firms cut capital expenditures,again, they're looking at that kind of
long-term investment, by five percentagepoints in the year leading to an election.
And that's the average effectthat are finding in firms in
the countries that are affected.
And I don't know if you want to godown this rabbit hole, but there is

(22:38):
a literature right now emerging onstate-owned enterprises and government
investments in general that finds theopposite: that leading to election,
state-owned enterprises and governmententities tend to ramp up investment.

Kate (22:52):
In countries like Brazil, China, and they do that to help
stabilize employment so that there'sno layoffs during election years.
That was the incumbent

Veljko (23:01):
was?
the

Kate (23:02):
current politician in power would get the votes

Veljko (23:04):
Correct.
So they're trying to do to itto help incumbents in power.
So if the average drop is 5%, whereasyou have at least some segments of the
market, which are ramping up employmentand investment, then you know that
the impact on the private sector isprobably even deeper the 5 percent cut.

Kate (23:22):
I am gonna throw in one more paper and there I'm gonna
go back to Tarek Hassan's work.
And he looks at the firm levelpolitical uncertainty, based on the
United States, but the findings areconsistent that he finds retrenching
corporate investment and hiring.
And there's another interesting kick.
Firms also actively lobbyand donate to politicians.

(23:46):
So they retrench investments, butthey increase their lobbying and
donations to politicians duringperiods of high political uncertainty.
Getting us back to investment during timesof higher political uncertainty, we've
talked about very tangible investments.
These physical, longer term projects.
But what about a differenttype of an investment?

(24:08):
Research looks at mergersand acquisitions, that's one.
But you can also think aboutthat as tangible investment.
And also research that looks atthe research and development a very
different type of an investment.
So let's summarize the findings of studiesthat look at mergers and acquisitions.
What happens to them duringhigh policy uncertainty?

Veljko (24:27):
I know of one this is Nguyen and Phan, published in the Journal of
Financial and Quantitative Analysis in2017, and the title is "Policy Uncertainty
and Mergers and Acquisitions." Once yourealize that policy uncertainty delays
investment... M&A is a type of investment,instead of buying individual assets,

(24:48):
you're buying a firm, a bundle of assets.
And just as individual investments incapital intensive assets is delayed,
so is investment in other firms.
So the volume of mergers, dropsdramatically, in the face of uncertainty.
There are also some slightlymore nuanced findings here.

(25:08):
One thing that the authors here find isthat, when political uncertainty is high,
it affects the cost of capital of firms.
It raises the cost of equity.
Shareholders want higher de returns tocompensate for this new form of risk,
but it raises also the cost of debt.
Bondholders want higherreturns for the same reason...

Kate (25:27):
interestingly, that is not the only study on policy uncertainty and M&As.
There's another paper by AliceBonaime, Hussein Gulen and Mihai Ion.
So a similar mix of authors, and that'sa 2018 Journal of Financial Economics
titled "Does Policy UncertaintyAffect Mergers and Acquisitions?"
So very straightforward, and ofcourse they find the same outcome.

(25:50):
Yes.
the, merger and acquisitionactivity is lower, when
political uncertainty is higher.
They also find that periods ofhigher policy uncertainty actually
increase targets negotiating power.
So apparently the target firmsare in the driving seat, and
they can ask for higher premiums.
So that is the summary of M&A papers.

(26:12):
What about....
R&D, research and development, avery different type of a beast.
This is an investment in something that'svery, undefined, unlike, CapEx or M&A.
It's innovative.
It drives the frontier ofknowledge forward, and we want
to see more innovation always.
So what happens to investmentin innovation during periods

(26:34):
of higher policy uncertainty?

Veljko (26:36):
I think that you're talking about a paper by Julian Atanasov.
The main finding of that paper, and Iremember it because it's counterintuitive.
At times of high political uncertaintyfirms are increasing their investment
in research and development.
I recall it because it'ssuch an unexpected finding.

Kate (26:54):
We have been on all doom and groom here on political uncertainty.
As political uncertainty increases,firms reduce their investments, there's
less activity, less growth, less hiring,and their paper is titled "The Bright
Side of Political Uncertainty." It isa paper by Julian Atanasov and Brandon
Julio and co-authors published in 2024in the Review of Financial Studies.

(27:19):
And they find an increase in firm levelresearch and development expenses in
those innovative activities duringperiods of higher policy uncertainty,
They use the EPU and also othermeasures for policy uncertainty.
Why does that happen?
As you're saying, everybody's pullingback investment, firms are not building

(27:40):
a factory, but they're investing in R&D.
Why?
The story that's told by Julian andco-authors is that the value of the growth
option, and obviously with this innovativetype investment, you don't know what the
payoff will be so, there's like highvolatility about what's going to
happen, but during times of economicvolatility, higher policy uncertainty,

(28:05):
the value of this growth option relatedto research and development is higher.
So firms actually invest more into R&Dbecause of this growth option value
being higher during uncertain times.

Veljko (28:20):
That's not what I would've expected, but I get
the rationale it's interesting.

Kate (28:26):
it's almost they, they're gambling on very long term outcomes.
Very long term outcomes.

Veljko (28:31):
I think it's time to rotate our conversation towards markets.

Kate (28:34):
You are saying you wanna get away from firms.
We've said enough about firms

Veljko (28:38):
I do.
And one of the overall messages isgonna be, if this is not great for
firms, it's probably not great formarkets either at an aggregate level.
But I think that this paper points outto one big idea that, at the end of
the day, uncertainty cuts both ways.
Uncertainty begets volatility andthis is where we, finance people,

(29:01):
have a weird definition of risk.
Risk, for the common person, isthe probability of something bad
happening, for us it's the probabilityof something unexpected happening.
Which means, high levels of risk, highlevels of uncertainty are hiding the
risk of something or the probabilityof something bad happening, but
they also carry the potential ofsomething good happening, right?

(29:23):
And I think this paper points out thatthere are opportunities in uncertainty.
And some firms are responding tothis by ramping up their investment.

Kate (29:32):
In R&D, the investment in R&D.

Veljko (29:34):
But I think it's a concept that investors should keep in mind as well.
This uncertainty is gonna be, you'regonna see in a moment, bad news for
markets as a whole, and yet they aregonna carry occasionally opportunities
for those who are brave enough to shoulderthe high levels of uncertainty risk.

Kate (29:55):
To summarize the part of our

Veljko (29:56):
our discussion of

Kate (29:58):
political uncertainty, where we've looked at firms,
basically it's very simple.
Firms just hit the brake on investment, ontangible investments, things like capital
expenditures, mergers, and acquisitions.
Yet they invest more into R&D.
Our next question is, what happens inthe overall market, the stock market?

(30:18):
What happens to, the bondmarket, how do they react?

Veljko (30:22):
Correct.
There are going to be two names thatwe will keep returning to here and,
we heard them before on our show.
We are

Kate (30:30):
talking

Veljko (30:30):
about Lubos Pastor and Pietro Veronesi

Kate (30:34):
Professors at the University of Chicago who have amazing, extremely
interesting work in this area of politicaluncertainty and in general, policy.

Veljko (30:42):
Indeed.
And the work you are referringto resulted in two highly
influential and highly cited papers.
The first one in the Journal of Financein 2012, " Uncertainty about government
policy and stock prices." The secondone, Journal of Financial Economics 2013,
"Policy Uncertainty and Risk Premia."

Kate (31:04):
So if I were to guess, and perhaps things are nuanced, but I would expect
that when political uncertainty is higher,there's a decline in the stock market.
But that's a simplistic view, isn't it?

Veljko (31:15):
Perhaps it is.
They are asset pricing people, and, ifyou've ever spent more than five minutes
talking to asset pricing people, you'veheard them talk about risk premia...

Kate (31:25):
Risk premia is compensation for carrying risk.
Investors want to be compensated.

Veljko (31:30):
But keep in mind there's two sides to this coin
is profits for investors, is ahigher cost of capital for a firm.
And effectively, this is badnews from a corporate side.
But the interesting implicationof risk premia are often in what
we call intertemporal dynamics.
What Pastor and Veronesi are telling ushere is that when policy risk increases,

(31:57):
investors both on the equity and debtside require greater compensation
for the risk that they're taking.
So,subsequently, firms have tooffer higher returns on stocks and
bonds in order to attract investors.

Kate (32:12):
Investors are are looking at policy uncertainty as a risk, as a priced risk.

Veljko (32:16):
Indeed, the 2012 paper is a theory framework.
The 2013 paper offers empiricalverification showing that this
is actually priced in securities.
The implication of this, when Iwas talking about the intertemporal
dynamics effectively mean, if a stockis gonna offer higher return tomorrow

(32:36):
or next period in the future, it'sbecause its price fell down today.
The return on a stock is ultimately yourdividend plus price appreciation divided
by the share price, if that share pricedeclines, your total return increases.

Kate (32:52):
So basically, if policy uncertainty is higher, historically
what we would expect is a short termdecline in the stock market, but "the
cherry on the pudding" is that there'sa long term higher returns because
investors want to be compensatedfor carrying this additional risk.
Like carry reward for holding yourbreath through all this uncertainty.

Veljko (33:15):
They, they do try to stay away from short versus long term.
They talk about a contemporaneousdecline and subsequently higher return.
So when policy risk materializesand while policy risk
persists, asset prices decline.
When that risk resolves, when thereis uncertainty resolution, you
should see a subsequent recovery.

(33:36):
This is only a theoretical framework,they have empirical verification.
There is also, other literature.
There is a 2015 Management Sciencepaper by Broogard and Detzel.

Kate (33:48):
I see.

Veljko (33:48):
It's a very similar paper.

Kate (33:50):
We had the double M and A studies.
I guess that just gives you additionalvalidity on the initial findings.
That helps sometimes.
Since we're talking about equity markets,we talked about the overall equity
market reaction, i'd like to talk aboutsome industry specific stuff, because
we've pointed out one type of industryis going to be more influenced, that's
industry with irreversible investment.

(34:11):
We would assume that they'regonna fare worse during periods
of political uncertainty.
Gulen and Ion actually do a bigbreakdown and they show that industries
that are most hit are those thatfeature irreversible investment.
Investment by companies that is veryhard to change, building a new factory,

(34:32):
starting a new project and creatinga new facility for that project.
So investments that would be veryhard to turn the clock back on.
So if the firm is working more withthis irreversible type projects,
they're more likely to pause them inthe face of political uncertainty.
What about other industries?

(34:53):
Are there any other industries that aremore sensitive to political uncertainty
or maybe some industries that woulddo better during times of higher
political uncertainties than thesecompanies with irreversible investments?

Veljko (35:06):
There is literature finding, first of all, that, regulated
industries tend to be affected more.
I believe there is a paperby Maria Boutchkova, right?
That, that finds that regulatedindustries, effectively industries such
as utilities or industries that tradea lot across the borders where the

(35:26):
government has more power over them,suffer more from political uncertainty.

Kate (35:29):
I see.
Yeah.
There's a paper by Butchkova thatlooks at industries across countries.
And, and as you are pointing outcorrectly, another area of sensitivity
in terms of industries are alsothose industries that are subject
to government spending naturallybecause of budget uncertainty like

(35:50):
the 2011 debt ceiling for example.
These type of industries would be underpressure not knowing what's going to be
coming in in terms of revenue and howmuch of the product will be purchased.

Veljko (36:02):
So of course if you depend more on government actions, government contracts,
government regulation, then you're moreaffected by government policy uncertainty.
Yeah, that, that makes sense.
There is one, perhaps slightly lessintuitive result in the literature
on corporate bonds and there is apaper by Wang, Wu, Yang, and Zhou.
This was published in the Review ofQuantitative Finance and Accounting

(36:25):
in... recently, February, 2025.
The title is "Policy Uncertaintyand Corporate Bond Issuance Costs."
And they in general find that whenpolicy and uncertainty goes up,
firms have to offer higher yields ascompensation for the additional risk.
But more pertaining to your questionin particular, they find that the
effect is more substantial for firmsthat have, more exposure to tax policy.

(36:49):
A lot tax rebates, tax cuts, taxincentives are actually at risk.

Kate (36:54):
It makes, it makes a lot of sense.

Veljko (36:56):
They find that the firms that are more dependent on external
finance are more exposed to policyshocks so firms that you know, are
mostly financed through reinvestedearnings are a little bit more robust.

Kate (37:07):
Right.
And those exposed to bankingpolicy uncertainty are more at risk

Veljko (37:11):
And then they actually find that the information environment of the
firm itself, the level of transparencyof the accounting of the firm strongly
relates to the reaction in, other words,what they're finding is that the firms
that are really cut out from fundingmarkets when policy uncertainty goes
up are the firms that have very lowlevels of accounting transparency.

(37:34):
So when the firm is not transparent andpolicy uncertainty is high, that's when
you're getting the really bad outcomes.
So that does seem to be someinteraction here between firm level
transparency and policy uncertainty

Kate (37:49):
It's not all firms are equally influenced by policy uncertainty.

Veljko (37:52):
Absolutely.
It there, there's variation both atthe industry and at the firm level.
I think it would be interesting tolook at how this maps to present time,

Kate (38:00):
So you are right, it's, so given what we've discussed from research,
which looks at historical trends, weexpect that during periods of high policy
uncertainty, and right now in 2025, we areat a period of extremely high political
uncertainty and policy uncertainty in theUnited States... we would expect that in

(38:20):
periods of high policy uncertainty, stockmarkets would decline, to then later, in
the long term, provide a higher return.
Yet, while we are at the period ofall time high political uncertainty, I
wouldn't say that we are at the periodof the lowest stock market levels ever.

(38:41):
How do we reconcile the two?

Veljko (38:42):
You're absolutely right there, there is a fundamental paradox at play.
Pastor and Veronesi are sayingpolitical uncertainty is related
to market volatility and toa decline in asset prices, at
least a contemporaneous decline.
And yet we've seen a spike inpolitical uncertainty and really
the market looks fairly flat,

Kate (39:02):
What can explain that?

Veljko (39:04):
Now, Pastor and Veronesi themselves tried explaining that.
They tried in 2017, they wrote acolumn in, think this was VoxEU.
Interestingly enough, this was
during the
first Trump administrationand at the time,

Kate (39:18):
EPU was high, at that time, it was the highest for that period of time,

Veljko (39:23):
it was the highest ever.
And yet it was a fractionof what it is now, right?
And even in 2017, this was the Trumpadministration talking about steel
tariffs, aluminum tariffs on China.
And again, there was alittle bit of back and forth.
One day it was tariffs on thenext day it was tariffs off.
And people were asking, whyis this policy uncertainty not.

(39:45):
materializing in stock market outcomes.

Kate (39:47):
it it was a lot of back and forth talking.
It's happening, It'snot happening, Correct.
It's happening.
It's not happening.

Veljko (39:52):
So Pastor and Veronesi at the time wrote this column in which they
were alleging that the lack of marketreaction was mostly due to the fact that
the market did not know how to parse theseinconsistent signals from the White House.
The market was discounting some of these,because again, when you have a policy

(40:13):
announcement on one day and the policyannouncement is reversed the following
day, eventually, you stop reacting.

Kate (40:19):
We have an equivalent of the story in Ukraine called Peter Cried Wolf.
, Or I guess that's a translationinto English, right?
Because Peter kept saying "wolf,wolf" and then nobody believes
Peter there is actually a wolf.
I feel like this is something similar.

Veljko (40:32):
I, I think that story exists in the Western vernacular.
We have Peter crying Wolf in Italy andit's of course Pietro, in Italy, and,
but, but anyways, and in general, theyalso lament a certain lack of detail in
this policy announcements, which theyclaim leads to a weaker market reaction.

Kate (40:51):
I see.
So do you buy this explanation?
I think I think there's something to it.

Veljko (40:54):
I buy the idea that the markets might delay and discount
to some extent the reaction,especially in the short term.

Kate (41:03):
So that's one hypothesis why political uncertainty that is high
now that's one of the explanations.
But it seems like you wanna throwin a couple of other factors factors

Veljko (41:10):
I think that this point is important,

Kate (41:12):
back to the Sherlock Holmes story.
What is not being said?

Veljko (41:18):
I love that way of putting it here.
But here is where we are gonna haveto have another episode in six to nine
months when we have some perspectiveand we actually have a little
little bit of better information,

Kate (41:29):
the benefit of the hindsight 2020 vision.

Veljko (41:31):
And yet, let me throw you what I think are candidate explanations.
Okay?

Kate (41:35):
Let's number them.

Veljko (41:37):
Number one, maybe something is happening.
You have a spike in policyuncertainty, Which affects virtually
every dollar denominated asset.
Correct?
And if every dollar denominated assetis losing value because of higher
degrees of political uncertainty, whatare we really expecting to happen?

(41:58):
Are we expecting every stock stock todrop, or maybe there's something else.
Maybe the valve thatgives is the US dollar.

Kate (42:06):
Oh, you're talking about the decline in the value of the US dollar, this
year it has declined by over 15%, right?

Veljko (42:14):
it was down, I think 17 percent

Kate (42:16):
right is

Veljko (42:16):
against major currencies at the bottom.
I think that it's recovered some butwe're still looking at 12 to 13% down.

Kate (42:22):
Okay.
So one explanation.
We're not taking everything into account.
We're looking at the stockmarket in US dollars.
While, you look at things more globally,the US dollar has declined in value,

Veljko (42:32):
And there is a very interesting paper, I think it
was Karolyi, Dodge, and Stulz.
They were asking "Are AssetPrices Global?" If you start
thinking about US stock pricesin euros, then they have dropped.

Kate (42:48):
Next candidate.

Veljko (42:48):
Next candidate is maybe tariffs and uncertainty are
pushing the market down, but thereare other forces pushing it up.

Kate (42:54):
What do you have in mind?

Veljko (42:55):
Tax cuts, we just went through massive tax cuts.

Kate (43:00):
Yeah.
Tax cuts are extremely important.
The Gulen and Ion paper, the 2016paper, they actually break down
policy uncertainty into tax policyuncertainty and other policy uncertainty.
And they show that corporate, firm level,investment declines in the response
specifically to tax policy uncertainty.
So there's been a lot of certainty broughtinto the tax policy and it looks, for

(43:26):
corporations and individuals of certainlevels, they'll be paying less in tax.

Veljko (43:30):
So you could have some trade uncertainty pulling markets down,
where you have some resolution orfiscal uncertainty pulling markets up.

Kate (43:38):
Right?

Veljko (43:38):
And the effect is a bit of a wash . Then you have the next explanation,
which think is the correct one.

Kate (43:44):
Number three.
Number three,

Veljko (43:46):
it's all about lags.
Give it a little bit of time

Kate (43:49):
Okay.
You think that the market hasnot yet reflected all of the
changes that are happening.

Veljko (43:57):
Even if you had perfect knowledge of what tariffs are going to
be over the next five years, what thetariff rates are gonna be vis-a-vis
each specific country, you still havea hard time parsing how this affects
each and every specific company.
Even if you are a sophisticatedinvestor, even if you spend your days
pouring over the balance sheets ofthis company, companies... I don't

(44:20):
think everybody appreciate how weaklydisaggregated data is of of U.S. firms.

Kate (44:26):
You mean in terms of their global sales, global
sourcing... from other countries?

Veljko (44:30):
The accounting principles that US firms use, actually allows for a
lot of regional consolidation of data.
So, you know how much Applebuys from Asia, right?
You don't know how much Applebuys in China versus Vietnam and
then maybe, you do, I dunno, I'mjust putting an example, right?

Kate (44:46):
I know that Nike sources over 90% of their products from Asia, but
they don't specify which country.

Veljko (44:53):
And now it matters, you have countries in Asia which have
tariffs at 10%, you have countriesin Asia that have tariffs at 50%.

Kate (44:59):
Right?
But they're also doing a little bitof a step around, just like in the
war between Russia and Ukraine, therewere financial sanctions on Russia.
And Russia stepped around them.
All of a sudden salmon was comingfrom like Azerbaijan or something.
China can step around things and supplythe same products from Vietnam, and
the tariff rates is gonna be lower.

(45:19):
So we don't know how thosesubstitutions will happen.
And we don't know even and wedon't know even in the first place
where the products are coming from.

Veljko (45:25):
Exactly.
And so I do believe in some weak formmarket efficiency at the end of the day,
and yet even I don't buy the idea thatthese tariffs are announced and the stock
prices of firms are immediately adjusting,taking into consideration the impact.
I just don't think we have clarity.
You need three to six months for thebalance sheets, income statements of

(45:45):
these firms to start giving us a picture.

Kate (45:48):
See what happens in January, February.
Yeah.
I would like to mention one more thing.
If you look back to 2000, 2005,and now, we as a country are
a lot more divided politically.
Where previously Democrats and Republicanscould talk to each other in a civil
matter now it's becoming less so.

(46:09):
There's been this rift of divisiveness.
Even though we are all in the samecountry, we all want very similar things.
This political party dividehas been phenomenal and it has
increased significantly since 2010.
There's an index of this partisanconflict index, which spikes exactly in
2010, has increased significantly since.

(46:29):
So in the United States, peoplehave become a lot more divided on
political topics, and perhaps that'smuting some of the effects some of
the effects of, political uncertainty.

Veljko (46:39):
Let me see if I understand your argument.
Let's say there is a segment of themarket that has rose tinted glasses,
and interprets every action taken by thecurrent administration as a positive.

Kate (46:50):
And then another that has a view that's negative.

Veljko (46:54):
Black tinted or blue tinted glasses.
I think this is a very interestingtopic for research going forward.
Whether increased politicalpolarization means that the market
is informationally less efficient,

Kate (47:07):
right?

Veljko (47:08):
Economic fundamentals matter less than your party affiliation,
and perhaps that's muting someof the transmission mechanisms of
these shocks into asset prices.
I'm with you there, And all of theseleads me to believe, I don't wanna
put words into your mouth, but Ithink we are due for a correction.

Kate (47:26):
Well, if you look at my paper as that examines firm performance
across presidencies, it basicallysays that the second years of
Republican presidencies, we see abigger decline in the stock market.
So, we will have a benefitof, 2020 vision next year.
We have fallen prey to whatwe ask students not to do.

(47:47):
We've talked about firms andequity markets for a long time.
But bond markets are significantlylarger than equity markets.
And we haven't said anything aboutthe bond market and the influence
of political uncertainty on bonds.

Veljko (48:01):
I do agree with your overall sentiment, but let me just say that
the Pastor and Veronesi models aboutrisk premia, they explicitly cover
both equity and debt instruments.
Although I think that the empiricalverification comes from the stock market.
When it comes to corporatebonds in in particular,

Kate (48:18):
We are gonna talk about both corporate bonds and US government bonds.
So, the borrowing by US government,it's called US treasuries.
There's bonds and bills.
Bills are like the shorter termborrowing instruments under two years.
Bonds, longer term, 10 years or so.
And corporate borrowingor corporate bonds.

Veljko (48:35):
We mean bonds issued by firms, right?

Kate (48:37):
McDonald's, Home Depot.

Veljko (48:39):
I think it's a very important distinction that you're making here.
On the corporate bond side,the story is at the end of the
day, a story of risk premium.
This policy risk is perceivedas an additional risk factor.
This additional risk factor meansinvestors require higher compensation,
which means that firms have to pay higheryields on bonds, right and of course,

(49:03):
higher yields imply lower bond prices.
So a drop in the price of corporate bonds.

Kate (49:09):
I see.
well, how does this translate intoUS treasuries, US government bonds?

Veljko (49:14):
You're right, there is a very important

Kate (49:16):
distinction here.

Veljko (49:17):
Whereas corporate bonds tend to be negatively effect by political
uncertainty through higher risk premium,on treasuries markets, on government
bonds, we have almost the opposite effect,if you will, due to flight to safety.

Kate (49:32):
The exuberant privilege, the United States

Veljko (49:35):
indeed,

Kate (49:35):
treasury market, government borrowing has held for years.

Veljko (49:39):
Let's spell this out for a moment.
Effectively, what flight to safetyimplies is that when risk levels
in markets spike, investorstend to gravitate towards the
safest form of assets available.

Kate (49:52):
I'm, I'm scared, I want my safety blanket with me.

Veljko (49:54):
Correct.
And the safety blanket for the worldfinancial markets is US treasuries.
So whenever risk goes up, thereis a certain volume of investment
that goes towards U.S. bonds.

Kate (50:07):
It's because U.S. has been historically seen as a country with high
level of legal protection and a countrythat's a very democratic country and
an economic really nexus of the world.
So it's been able to use this exorbitantprivilege effect because of this.

Veljko (50:27):
The point is, when risk goes up, investors demand US bonds...

Kate (50:32):
They
want to buy US treasuries the higherdemand for treasuries brings about
higher prices and lower yields.
You would think there's higherpolicy uncertainty, people should
run away from US treasuries, whichwould push prices down and yield up.
But the effect is the opposite.
They're coming towards the treasurymarket, pushing up demand for it,
pushing up prices, pushing theyields down, flight to safety.

Veljko (50:54):
Absolutely.
And one example that everybodyloves to cite when talking about
flight to safety is the 2011 debtceiling crisis in United States.
Where effectively, for the firsttime, in the summer of 2011, the US
was openly considering defaultingon a bond payment default in
this case is a technical default.
It's a late payment, not a missed payment.

(51:16):
And yet, this created policy uncertaintyreally all over world with the result that
investors all over world paradoxicallyflocked into US treasury markets.
So you had this policy uncertaintycreated by the US government
directly affecting the likelihoodof default in US debt markets, and

(51:37):
an increase in the likelihood of
default And paradoxically,everybody's buying US treasuries.

Kate (51:41):
from what I understand also, they are buying more shorter term
US treasuries something with an expiration over the next two years.
So, they're mostly buying T-bills.,So they're pushing the yield of these
treasury bills down the shorter term...

Veljko (51:54):
You're looking at a paper by Marcus Leipold and Felix
Matthys here, published in, 2022.
"Economic Policy Uncertaintyand the Yield Curve." What

Kate (52:03):
they

Veljko (52:04):
emphasize is
that when the risk goes up,you go to the safest asset.
The safest

Kate (52:09):
asset is

Veljko (52:09):
often
a US treasury bond, but notjust a US treasury bond.
A short maturity US treasury bond.
So

Kate (52:18):
Treasury bill.

Veljko (52:19):
Effectively

Kate (52:20):
bill.

Veljko (52:20):
so effectively what they're saying is that the flight to safety
effect tends to push yields downfor shorter maturity US treasuries

Kate (52:28):
because there is more demand for them.
Prices go up, yields down...

Veljko (52:32):
but, not so much long term.

Kate (52:34):
Yeah.
So that would create a steepening of theyield curve because if the term is pushed
down and the long term is even the same,

Veljko (52:41):
correct.

Kate (52:42):
The yield curve is gonna be steeper.

Veljko (52:44):
Under normal circumstances the yield curve has a positive slope.
Long-term yields are higherthan shorter term yields.
The bottom line is that bondtraders like to say that policy
uncertainty steepens the yield
curve.

Kate (52:55):
since we are being a bit geeky and talking about yield curves,
let's talk about the yield spread.
So because there's this flightto safety demand for treasuries,
which pushes the yields down.
Similar dynamic doesn't happen forUS corporates, so they actually
have to offer higher yield to bondinvestors in times of uncertainty.

(53:16):
This also widens the spread betweenUS Treasury or what the US government
needs to pay as interest to theirproviders of capital versus what
US firms need to pay us interest ontheir debt to providers of capital.

Veljko (53:30):
The term spread increases, the difference between short and long
term maturities, but also the spreadbetween government and corporate.

Kate (53:38):
Okay.
I feel much better now that we'vecovered what happens in the bond market.
Makes me feel better.

Veljko (53:44):
Okay.
By the way, let me ask you abit of a trivia question here.
Do you know when the UK bondmarket had the lowest yield?
The equivalent of treasuriesin the UK are called gilts.

Kate (53:56):
Right.

Veljko (53:56):
When the gilts had the lowest yield ever?

Kate (53:59):
it's probably gonna be something extremely weird like the 2012 debt ceiling
because there was a flight to qualitytowards the US treasury bonds weirdly.
So then if you're asking me that, Iwould have to guess that maybe something
around the Brexit vote where you wouldexpect the opposite, but that might
maybe people went out and bought guilts

Veljko (54:19):
And that's exactly what it was.
The lowest yield ever on

Kate (54:22):
flight to safety

Veljko (54:23):
on UK gilts was after the Brexit vote.

Kate (54:26):
Wow.

Veljko (54:27):
And stock markets dropped like a brick.
But a lot of peoplestarted buying UK bonds

Kate (54:32):
Because they were taking their money from the stock market,
whereas they going to put them.

Veljko (54:36):
Yeah you gotta put it somewhere

Kate (54:37):
we've talked about equities.
We've talked about bonds.
We've also mentioned that in theequity market there's historical
findings, and then there's 2025.
And discussed some issues there.
What about for bonds?
The historical findings we're discussing,are there any weird quips that are
happening in 2025 for US bonds?

Veljko (54:56):
Well, there are, and it comes down exactly to this flight to safety
mechanism that we're discussing.
And we love to talk aboutacademic research and yet not
all great research is academic.

Kate (55:07):
I think what you're referring to is... on Liberation Day, whenever
the tariffs were announced, we had anextreme reaction in the bond market.
And if one would think about the flightto safety, they would think people would
wanna buy US treasuries, US governmentborrowing instruments, US bonds,
pushing their prices up and yields down.

(55:29):
But we've seen that the opposite happened.
The yields on US treasuries wentway up, increased dramatically.

Veljko (55:38):
I was referring to something that I've seen published by the
Economist Intelligence Unit.
And they effectively are looking atthe correlation between uncertainty
and bond yields on US markets.
And as a proxy for uncertainty,they're using the VIX.
The VIX is, the volatility indexis also known as the fear gage.

Kate (55:57):
It's how volatile the S and P 500 is.
The Standard and poor's 500 largest firmsin the US, how volatile their stocks are,

Veljko (56:04):
Correct.
Historically, what they show is that,when the VIX goes up, bond prices,
treasury bond prices tend to go up.
US treasury bond prices.
When things get more volatile, morescary, when policy uncertainty
is high, people run to buy bonds.
And yet over the last six months,we have seen the opposite.
We are seeing a negative correlationbetween the VIX and US treasury prices,

(56:28):
implying that as uncertainty goes up,bond prices are actually dropping.
Even short term treasuries aredropping and yields are going up.
So there is a question whetherthe traditional flight to safety
mechanism has broken down.
And what that means for USgovernment borrowing going forward.
And I will also say, traditional flightto safety affects US treasuries, but

(56:52):
it also tends to affect the US dollar.

Kate (56:54):
Right?

Veljko (56:55):
Usually when bad things happen worldwide.
The value of the US dollar goes up.
And here we've seen a spike in policy riskand the value of the dollar has actually
declined fairly dramatically against otheroccurrences, which again, reinforces this
idea that which you call the exorbitantprivilege of the United States or what

(57:17):
we call the flight to safety mechanism,it might actually not be working.
Now if you dig into the literatureon the flight to safety, different
types of uncertainty tend toaffect things differently.
There is some literature finding thatwhen monetary policy is uncertain,
flight to safety tends to break down,

Kate (57:35):
I see

Veljko (57:35):
so perhaps talking about firing the Chairman of the Fed has
a bigger impact on bond yieldsthan trade policy uncertainty.
So, some of this flight to safety might bebreaking down, but again, I think it's too
early to interpret all of these signals.
But I don't think it's too earlyto formulate some hypothesis and to
start monitoring what's going on.

(57:56):
Unfortunately, as researchers, we do needa little bit of time and perspective.
This research does give us some guidanceand yet we are in uncharted waters.
This research is a compass.
It's not a detailed map.
We talked about equity markets,we talked about bond markets, but
there is research out there findingthat investors can actually use

(58:18):
successfully derivative markets andoptions to hedge some of this risk.

Kate (58:23):
you're talking about the Bryan Kelly, Lubos Pastor and Veronesi,
Pietro Veronesi, 2016 Journal of Financepaper, where they look at the options
market right around elections in the US.
So they look at the option that spansthe election period and compare it
to an option that ends before it.
And they find that the options thatspan elections are more expensive.

(58:45):
In other ways, saying thatinvestors want additional
protection for this political risk.

Veljko (58:51):
Absolutely.

Kate (58:52):
is the first very direct measure of political risk there.

Veljko (58:57):
But clearly this is a set of tools that's more easily available
to a sophisticated set of investors.

Kate (59:03):
All, all Robinhood users.

Veljko (59:05):
That's, that's that's a whole other door.

Kate (59:06):
Okay.
I'm gonna call for a summary.
We've talked so much aboutuncertainty measures.
We've talked so much aboutwhat do companies do when
political uncertainty is high?
We've talked about the equitymarket, the bond market.
So let's summarize.
If we connect all of these threatstogether into a bigger picture.
there's a very consistent messageacross top academic papers.

(59:30):
The message is very clear.

Veljko (59:32):
Policy uncertainty depresses economic activity.

Kate (59:35):
Investment.
Corporate investment is down anywhere from9% in the United States, to 5% globally.
During election years.

Veljko (59:44):
Correct.

Kate (59:44):
What about the overall equity market?
What we see in the equitymarkets historically

Veljko (59:49):
it's an increase in risk premium.

Kate (59:51):
It's an increase in risk premium, and the bond market.

Veljko (59:53):
And the bond market, we have nuanced effects.
There is this increase in riskpremia that tends to depress
the value of corporate bonds.
There is a flight to safetyeffect that tends to increase the
value of short term treasuries.

Kate (01:00:07):
For the stock market, this idea is that there are short term pains that
can predict long term gain and this

Veljko (01:00:13):
idea of

Kate (01:00:14):
premium where you are getting paid for carrying this political risk.
For the bond market, it's been abit of a shuffle for the US with
this flight to safety, but it soundslike all of these are important
for personal investment decisions,also, obviously for policy making.
So why don't we talk a bit about someindustries that are more susceptible and

(01:00:36):
less susceptible to policy uncertainty.

Veljko (01:00:39):
I think it's interesting to look at it both across asset
classes and across industries.
I think the bigger question here is,given this research, what can a portfolio
manager or somebody managing their ownretirement account, draw out of this?
First of all, we need to understandthat policy uncertainty is bad news.

Kate (01:00:59):
but news, especially for sectors that have irreversible
investments, long-term projects.

Veljko (01:01:05):
If you want to try to classify the firms that you really stay away from, you
stay away from capital intensive firms.
You stay away from firms that relyoverwhelmingly on external finance,
because your ability to raise capitalcapital externally is particularly
affected by policy uncertainty.

Kate (01:01:21):
Firms that are very dependent on government contracts
and government spending,

Veljko (01:01:25):
correct?

Kate (01:01:25):
there's a lot of uncertainty about it

Veljko (01:01:27):
By definition.
This is where theuncertainty's coming from.
I think that inherently when theuncertainty's coming, like now
from trade policy, from the tradeside, it tends to affect services
less than say manufacturing.
Services tend to sell locally.
They tend to have fewercapital intensity inputs.

Kate (01:01:49):
Of course, services would still be depressed by an overall
market depression, but you are sayingyou would be long services, short
firms with high capital expenses.

Veljko (01:02:00):
Policy uncertainty is bad news overall, we are really asking the question
where are are you gonna take less damage?
And at the end of the day, you'reexpecting services to be less, less
negatively affected than manufacturing.

Kate (01:02:11):
So it's all relative.
It's not that servicesare gonna do stellar.
It's, they will be not as bad.

Veljko (01:02:17):
Not as negatively affected.
In general, when policy uncertainty iscoming from trade, small firms tend
to be less affected than large firms.
There's a lot of research findingthat large firms tend to have
more international supply chains.
They tend to sell more abroad.
So small firms in some sense, it'snot that they're not affected, they're
less affected, by all of these.

(01:02:38):
But ultimately, there is only one answerin finance that's always correct, Kate.
When it comes especially to themanagement of your portfolio.
And what is that?

Kate (01:02:48):
that's the one that we tell all of our, it's a textbook answer.
That's diversification.

Veljko (01:02:53):
You read my mind.
As risk goes up, and policy risk isjust one more form of risk, your
benefits of diversification increase,

Kate (01:03:02):
across asset classes,

Veljko (01:03:03):
Across countries, across asset crisis, across time horizons.

Kate (01:03:07):
And I think this gives a nice map to our listeners.
However, I would also like to throw inone more thing if our listeners are policy
makers, because one thing that can helpin this situation and research points
this out is clarity, is transparency.
The more guidance, the more transparentguidance that can be provided to

(01:03:29):
the markets, the less ambiguity,the less uncertainty, and it really
helps markets comes to terms.
more clear guidance, moretransparency, better clarity, would
be very important if possible.

Veljko (01:03:41):
The Federal Reserve, that unfortunately is under so much
attack right now, they made abig deal about forward guidance.
whether we think they're doing itright or not, they do seem to recognize
the importance of not just, notjust about having the right policy.
It's about communicating thepolicy in an effective manner.
Our politicians can learn a little bit.

Kate (01:04:01):
Yep.

Veljko (01:04:02):
From our regulators.

Kate (01:04:03):
We've summarized things.
We've talked talked about industrieswhich could be less affected by policy
uncertainty and more affected abouthow politicians should be more clear.
Let's have some final thoughts here.
Uncertainty causes businesses todelay investments, big investments,
and that makes markets demand ahigher risk premium, equity markets.

(01:04:25):
All of these periods of prolongedambiguity, political uncertainty,
they do bring about reductions ininvestment and providing clarity is
important from a policymaker standpoint.

Veljko (01:04:40):
What I hope our listeners take away is that this idea of
political uncertainty is not justan abstract academic philosophical
concept, but it's actually a riskfactor that is priced in markets.
And again, we want to have an edge, and ifyou look at today's pricing models, there

(01:05:01):
is is no political uncertainty factor,this is the frontier of our research.

Kate (01:05:05):
So another thing to add here is we are in a very nuanced situation.
We keep saying for researchers and foreverybody, this next year, next few
years are going to be very interestingto see how for things unfold.
But, we are in a situation wheresome of the historical trends are
being buckled against right now.

Veljko (01:05:24):
Indeed.
It's also interesting, and I thinkwhat you're hinting at here is
effectively if you want to invest onpolicy uncertainty, it's about market
timing more than the cross section.
It's a market wide phenomenon.
And certainly some firms are more exposedto policy and uncertainty than others.
But ultimately, you wanna be shortingthat market while policy uncertainty

(01:05:46):
is high and you wanna be long whenthe policy uncertainty is resolved.
And can you really, time that switch?

Kate (01:05:53):
Time the switch and time the switch in market perceptions, moreover,
which things a lot more difficult.

Veljko (01:05:58):
Good luck to anybody trying to time this, the usual disclaimer

Kate (01:06:02):
We're not recommending the timing, we're not providing any trading advice.
We want to provide a shortcutinto understanding research.

Veljko (01:06:09):
I will mention we, we've had an email address for a while and yet
we failed to advertise it in the past.
So questions@questionsinfinance.com,

Kate (01:06:21):
Altogether, no spaces.

Veljko (01:06:22):
Please send us your questions.

Kate (01:06:24):
thank you for listening

Veljko (01:06:25):
Cheers.

Kate (01:06:26):
Cheers.

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How Does Policy Uncertainty Affect Investments?

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