Something evil this way is coming, looming volatility under $TRUMP 2.0

As we enter 2025, the financial markets present a peculiar dissonance. On the one hand, we have stock markets near record highs, supported by expectations of lower interest rates and a soft landing. On the other hand, we have a rapidly escalating Economic Political Uncertainty Index (EPU) that paints a very different picture of the road ahead. This divergence is not just unusual; it’s a clarion call to investors to prepare for impact.

The EPU index, a critical tool for forward-looking investors, has risen to levels not seen since the start of the pandemic. This increase is largely attributed to the uncertainty surrounding “Trump 2.0” – the potential policies of another Trump administration. While markets often climb a wall of worry, this wall looks more like a rock.

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 growing anxiety about economic policies. In recent months, this index has reached levels last seen during the peak uncertainty of the pandemic.

As illustrated in the diagram below (2)The EPUCTRAD index often heralds spikes in the VIX. Consider the 2019 US-China trade war: EPUCTRAD shot up, followed by a volatile VIX. The same thing happened in 2020 during the pandemic-driven economic shutdown:

Today, the scenario is eerily familiar. The renewed political landscape under the Trump administration brings with it contentious trade policies, unpredictable regulations and global tensions – all adding to rising uncertainty. This is not just a headline risk; it is a tangible shift in market dynamics.

History teaches us that the EPU is not just a reflection of current concerns, but a harbinger of future market volatility. Time and time again, we have observed that a rising EPU precedes a rise in the CBOE Volatility Index (VIX), often referred to as the “fear gauge” of the stock market. The relationship is clear: as political uncertainty grows, so does market volatility – and with it the potential for significant market corrections.

What is particularly alarming about the current situation is the size of the EPU increase. We are seeing levels that eclipse those observed in the initial stages of the COVID-19 pandemic. This suggests that the market has not yet fully priced in the potential consequences of another Trump term.

Market corrections: Why VIX spikes signal an imminent end

Bear markets are as much about psychology as they are about economics. Selling into a falling market is emotionally draining and financially challenging. Historically, VIX spikes align with the final stages of a correction.

So far, we have yet to see a definitive VIX rise in the current correction cycle, signaling that markets may not have bottomed out (2):

From 1990 to 2022, the data shows a consistent pattern: VIX not only predicts corrections; it tends to culminate them. For investors, this means that the absence of a rise to ~50 suggests that there may be more turbulence on the horizon. When the VIX eventually rises, it is often the emotional and financial apex of market distress.

The consequences for investors are great. While the VIX is currently hovering around relatively benign levels, history suggests that this calm is likely to be short-lived. This shift between the soaring EPU and subdued VIX resembles a coil spring – the tension is building, and when it releases, the movement can be swift and severe.

It is crucial to understand that increased volatility is not just about increased price swings; it is typically associated with lower share prices. As uncertainty grows, risk premiums increase, causing investors to demand higher returns for the same assets. This in turn puts downward pressure on valuations.

In addition, the sectors most vulnerable to policy changes—health care, energy, and international trade-dependent industries—could experience major impacts. The potential for sweeping regulatory changes, shifts in trade policies and health care law changes under another Trump administration creates a minefield of uncertainty for these sectors.

For those who argue that the market has already priced in a Trump victory, I would caution against such complacency. The current EPU levels suggest that we have only begun to scratch the surface of potential policy-induced volatility. The full range of possible Trump policies—from tariff escalations to immigration crackdowns—has yet to be fully digested by the market.

Navigating the way forward

So what should an investor do in the face of this looming volatility storm? First of all, you need to reassess your portfolio’s risk exposure. This is not the time for complacency or overconcentration. Diversification, both across and within asset classes, becomes even more critical in times of increased uncertainty.

Consider increasing the allocation to assets that historically perform well during periods of volatility. Gold, for example, often serves as a safe haven during market turbulence. Ultra-short-term investment-grade credit can also prove valuable, offering a balance of returns and relative stability in uncertain times.

For the more tactically inclined, the current situation offers opportunities in the volatility market itself. With the VIX at relatively muted levels despite the rising EPU, strategies that benefit from an increase in implied volatility may be particularly attractive.

There is a clear warning sign that market volatility is likely to increase, potentially significantly. We are not just facing a bump in the road; we are looking at a seismic shift in the market landscape. The current disconnect between the EPU and the VIX is unsustainable. As the reality of political uncertainty sets in, we can expect the VIX to catch up, bringing with it the potential for significant market declines. Investors who heed this warning and position themselves accordingly will be better prepared to weather the storm and potentially take advantage of the opportunities that volatility inevitably creates.

Remember that in the investment world be forewarned. We believe that the EPU is sending a clear signal – something sinister is coming this way. It’s time to batten down the hatches and prepare for turbulence ahead.