The relationship is strong enough to quantify. Over the past two decades, changes in the Economic Policy Uncertainty Index (EPUI) – an index of political risk and policy uncertainty – have explained roughly 20% of the variation in the VIX Index (a measure of the implied volatility on the S&P 500).
For most of the past year, the EPUI has been moving lower. However, beginning in late summer, the indicator started to increase as the noise around the budget battle heated up. The measure increased by roughly 60% from August to September, and the September jump suggests that, all else equal, volatility (i.e. the VIX) should be two or three points higher than the prevailing level in August. In addition, should the indicator move back to the levels witnessed during the summer of 2012 – a real possibility as there are also political rumblings in parts of Europe – this would suggest that the VIX will rise to the high teens, closer to its long-term average.
And as there’s a very good chance that Washington will produce yet another temporary patch to avert a default (for example, a hike in the debt ceiling that only lasts three months), we’re likely to be back in the same position a few months down the road.
In short, if political uncertainty over the budget and debt ceiling becomes a semi-permanent fixture, market volatility is likely to remain higher than the summer’s placid levels. Under this regime, investors may need to reacquaint themselves with what a more volatile world feels like.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist.