Markets Hate Uncertainty

I thought this might be a good time for a brief primer on the likely consequences of the ever evolving US economic policy.

One of the first things you learn as an investor is markets hate uncertainty.

This is basically a way of stating that people are risk averse so they tend to avoid stocks with an unresolved issue, even if they are cheap. This is why you see companies pay to settle bogus lawsuits like talc, Roundup, asbestos, etc.

It’s not just that the cost to defend these cases is high. It’s that the stock price suffers while the outcome is unknown.

It’s why you often see the stock go up when companies overpay in settlements. It’s not that the market concludes that the company got a bargain.

Rather, the removal of the uncertainty brings buyers off the sidelines, even though they know the company paid too much to settle.

This same principle applies to the private economy. When businesses don’t know what the rules are going to be, they effectively become paralyzed.

Imagine being a manufacturer that imports components from overseas. Which country should you source them from?

You probably already moved some of your Chinese supplies to Vietnam or Mexico, but, well, now Mexico may be uneconomic, so what do you do?

What you do is not expand your business. Because you hate the uncertainty.

Where does that lead?

Animal Spirits

You’ve all probably heard the famous Keynes’ quote about animal spirits. Uncertainty is the withdrawal of animal spirits. It’s animal hibernation.

Consumers don’t want to spend money because they are uncertain of their job or feel they are unlikely to get a raise. This reduces demand.

Businesses won’t expand or develop new products. It will take a higher potential return for them to bear the uncertainty. This restricts supply.

Less supply means higher prices which, in turn, reduces demand further.

You can see below in my crudely drawn supply demand curves how we move from E₀ to E₁ as a result of leftward shifts in supply (lower output at the same price) from S₀ to S₁ and demand (people buy less at the existing price) from D₀ to D₁.

This new equilibrium results in lower economic activity, i.e. a recession.

In this example, prices are steady, so no change in inflation, but inflation could increase or decrease easily, so don’t be fooled by the drawing.

It’s too complicated an analysis for these purposes, but to oversimplify, if the demand shock is greater than the supply shock, prices will fall and they will rise if the supply shock is larger.

Note, the graph does not include the actual impact of tariffs. That is a separate analysis, so add that negative impact on top of this. I am only focused here on the impact from increased uncertainty.

Making America European Again

You can think of E₀ above as the US economy you know and love and E₁ as the European economy you’ve seen stagnate for decades.

One of the biggest reasons European economies have lagged the US is the difficulty in starting new businesses (and expanding successful ones).

This is due more to heavy regulation than tariffs but the result is the same. The high uncertainty keeps animal spirits in hibernation so returns need to be very high to be willing to roll the dice on a venture.

History has shown that reversing the psychological effect of hibernation is very difficult and often traumatic. You can think back to the heavy lifting Reagan and Thatcher had to do or what Millei is trying to pull off in Argentina.

A future President can repeal the tariffs, but he or she may not be able to reverse the accompanying malaise.

Lower Capital Returns

What other ramifications are there from increased uncertainty?

The reduced investment by businesses means savings will be higher (by definition, less spending means the savings rate is higher). The problem is those higher savings have no place productive to be invested.

So we get more savings but at lower returns. Add another one to the minus category for increased uncertainty.

But wait, there’s more! One benefit of having higher returns on investment than the rest of the world is it attracts a lot of foreign capital.

This foreign capital is more than happy to sell us their cheaper goods and fund our trade deficit because they get paid well for their trouble.

If they sell us a lot of goods, but don’t have a way to recycle their current account surplus into buying US investments, that becomes a problem.

If they don’t want to open US plants or buy US office towers, then they have to park their money in Treasury bills.

This can lead to one of two outcomes – either they demand higher US interest rates to compensate them or they sell their $ which weakens our currency and raises the price of imports leading to inflation.

Either way, Americans lose. We get either higher prices or higher borrowing costs.

And on top of that, our domestic savings earn the same lower returns on investment that scare away our trade partners.

It is hard to draw up a worse outcome for everyone. Uncertainty is a true lose/lose where 1 + 1 = -1.

It’s like playing prisoner’s dilemma but where both prisoners confess and still get life sentences.

A Better Solution

So what would an intelligent plan look like that would make America more competitive while increasing certainty?

Reduce government spending. No, not in the crazy DOGE way that, once again, increases uncertainty, but in a thoughtful bipartisan way that provides the most bang for the buck.

And before someone objects that I’m offering an unrealistic solution, nobody would have predicted 30 years ago that Bill Clinton and Newt Gingrich could find common ground.

How does lower spending help? For one, it lowers interest rates since we don’t need to issue as much debt.

Two, it’s sort of like a stock buyback. It takes “excess capital” out of the government and returns it to the private sector where it can be employed more productively.

Three, by making it easier to do business in the US, it reduces frictional costs which allows US manufacturers to overcome part of their inherent wage disadvantage vs. foreign competitors. So you get more domestic jobs without lose-lose tariffs.

The goals of tariffs could be accomplished with far less pain and uncertainty.

Resolution

So how do we put an end to this since a Clinton-Gingrich bipartisan solution seems unlikely? You have to do what corporations do.

Pay off the trial lawyers to make the overhang go away.

In this case, it would mean compromising with other countries even if you don’t get the best deal. Removing the uncertainty will keep the economy out of a lengthy recession.

After all, the best way to improve the deficit isn’t to let DOGE cut costs or to raise taxes. It’s to improve economic growth.

Faster growth doesn’t just lead to more taxes collected. It leads to more employment, wealth creation, etc. It’s a case where 1+1 = 11.

So if uncertainty is the enemy of economic growth, it appears the solution is very simple – remove the uncertainty!

A government policy of intentionally increasing uncertainty is a massive unforced error. There is nothing to be gained from playing Russian Roulette with the economy.