Stock Market Faces Risks Amid Policy Uncertainty and Dollar Impact
The unpredictability of government policy and the influence of the dollar in the international financial system could pose significant challenges for stock markets in the future.
In recent days, stock prices have experienced a decline as investors begin factoring in potential downsides tied to the policy decisions of the Trump administration.
Concerns have grown about the extent of cost-cutting measures undertaken by DOGE and the potential impact of tariffs on global economic expansion. These fears have influenced various indices that track policy-related developments. A recent survey conducted by the University of Michigan indicated an increase in negative sentiment regarding government actions.
Moreover, an index measuring economic policy uncertainty in the United States has seen a significant rise lately. However, despite this development, there has not been a corresponding increase in credit spreads or a substantial surge in the VIX, which historically tends to occur in such circumstances.
At present, the stock market finds itself in a precarious balance.
A combination of low volatility, narrow credit spreads, and declining index correlation forms a delicate foundation that could magnify any downturn in stock prices. For example, a widening of credit spreads would likely lead to an increase in the VIX, which could then result in the unwinding of dispersion trades. This could compel further purchases of index volatility, ultimately triggering market sell-offs due to gamma-related forces.
The risks associated with these market conditions are further heightened given that stock valuations have reached unprecedented highs.
Households now hold the largest proportion of stocks, with their ownership of equities relative to their total financial assets also reaching record levels. Should this investor group exhibit risk aversion, stock valuations could swiftly undergo a sharp correction.
Adding to the complexities, discussions about a potential agreement at Mar-a-Lago aimed at addressing external imbalances in the United States could further weigh on investor sentiment.
In recent years, foreign investors have demonstrated a remarkable enthusiasm for U.S. equities, with a level of investment unmatched in prior years. Since the pandemic, international entities have poured nearly $9 trillion into U.S. stocks, bringing their total holdings to nearly one-seventh of all outstanding U.S. equities.
Should the ownership of dollars come with additional stipulations and heightened risks, it could prompt foreign capital to exit U.S. financial markets, affecting both stocks and bonds.
The convergence of rising yields, increasing policy uncertainty, and the flight of capital creates a challenging scenario, even for an economy as historically resilient as that of the United States.