Quick Thoughts: Risk vs. uncertainty

Originally published in Stephen Dover’s LinkedIn Newsletter, Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Uncertainty prevails. Risk can be factored into investment decisions. Uncertainty cannot. 

Recent US economic data are coming in softer than expected. Should that trend persist, economists will soon downgrade forecasts for 2025 US gross domestic product (GDP) growth. Downward corporate earnings revisions are already underway. Investors seem more uncertain about the future than usual, and this shows up in a weakened equity market.

Why is this happening now? Wasn’t the US economy on a solid footing?

Indeed, at the end of last year, US unemployment was low, real wages were rising, corporate profits were strong and the US Federal Reserve (Fed) was easing. Hopes for tax cuts and business-friendly deregulation were captivating the worlds of commerce and finance. By all accounts, 2025 should have been a banner year for the US economy, corporate profits and capital markets.

What lies behind today’s gloomier outlook? I think the primary culprit is uncertainty stemming from chaotic governance policy in Washington, DC.

Risk is something that can be quantified and approximated via probability distributions. Even in the presence of significant risk, investors can still act to maximize their returns by incorporating probability-based thinking to assess the likelihood of future outcomes.

Uncertainty, on the other hand, is beyond measure. It cannot be known nor estimated and therefore paralyzes decision-making.

How to deal with uncertainty

Since we don’t know what’s ahead, we need to be even more mindful of the data. 

Over the first two months of 2025, many economic indicators have turned more negative. The first blow was consumer sentiment. In February, the University of Michigan household survey plunged to 64.7, a tumble of 9% from January’s level and 12.5% below December’s reading.¹ Little surprise, when consumers are uncertain, they turn more negative about the future.

The Conference Board’s survey of sentiment tells the same story. Its February reading fell to 72.9, below the 80 demarcation line that the Conference Board believes is indicative of a forthcoming recession.²

There’s more. The February ISM manufacturing survey of supply managers revealed falling new orders and a drop in manufacturing employment. Supplier deliveries, a leading indicator of industrial demand, slowed to a standstill. According to the survey: “Demand eased, production stabilized, and de-staffing continued as companies experience the first operational shock of the new administration’s tariff policy.”

Even a traditional lagging indicator—the labor market—is easing. The four-week moving average of jobless claims is edging higher. The ADP survey of job gains fell to 77,000 new jobs in February, down from its six-month moving average of 167,000.³ The February employment report showed a gain of 151,000 jobs, but within the detail, that figure overstates the health of the labor market. Most job gains were in non-cyclical sectors, and big federal government layoffs occurred after the survey period.

Broader measures of US economic activity are also worrisome. The Federal Reserve Bank of Atlanta’s estimate of first quarter 2025 real GDP growth has plunged from 3% six weeks ago to -2.8% on March 3, 2025.⁴ Even if some of that decline may be due to accelerated imports (to get ahead of tariffs), the same report noted that as of early March US consumer spending has flatlined and business investment is barely growing.

Wall Street’s earnings estimates are being revised downward. According to FactSet, first quarter 2025 earnings estimates are falling for all 11 sectors, led by cyclical sectors, such as materials (-16.2%) and consumer discretionary (-8.8%).⁵ FactSet also notes that downward revisions are greater than typically seen at this time of year.

Markets have started to take note. US 10-year Treasury yields have slid nearly 50 basis points from their February highs,⁶ the yield curve has flattened, and the US S&P 500 Index has given up its 2025 gains. Measures of market risk are rising, including the widely followed VIX index.⁷ Daily market moves are becoming more volatile, led by the number of -1% red days.

The likely culprit: Uncertainty

So why is the economy slowing and why are the markets shaking?

The most likely culprit is uncertainty.

How do we know? Because almost nothing else has changed for the worse. Other adverse shocks are absent. Job growth remains positive, as do real wage gains, which have been rising for 19 consecutive months.⁸ Households and businesses have been buoyed by big gains in wealth and declines in the cost of capital over the past two years.

Other things should have lifted growth, including hopes for sweeping business deregulation and tax cuts or falling oil prices. Animal spirits⁹ should be booming, not slumping.

The challenge surely is the discombobulating jump in uncertainty in Washington, DC, spanning international trade, government employment, US foreign policy, and much more.

Politicians who break the mold and adopt unconventional approaches can change the debate. They may even deliver tangible results, including reducing wasteful spending or imagining fresh solutions to problems at home or abroad.

But the unconventional is not costless. Mass layoffs of government workers, flip-flops on tariffs, the excessive use of executive orders (as opposed to legislation, which is more difficult to reverse), and shifting allegiances from friend to foe all spawn uncertainty.

Nearly everyone in the economy is struggling to comprehend wild swings in Washington policies, and their implications for everyday decisions. Probabilities based on historic norms are rendered useless by discontinuous change. Likelihoods of future outcomes are unknowable.

The result is economic paralysis.

For instance, if US automobile makers were certain that 25% tariffs will be permanently applied to components manufactured in Canada or Mexico, they could plan and invest accordingly. But when tariffs flip-flop, investment freezes. After all, automaker manufacturing commitments are massive and meant to last for decades. No reasonable auto executive can make such investments if the expected returns can be wiped out at the stroke of a pen.

Other sectors are in similar predicaments. Health care, retailing, agriculture, mining, energy, and other industries are grappling with the unknown. Dramatic shifts in rhetoric and policy challenge longstanding assumptions about US commitments ranging from national security to government spending on the biggest social programs, including Medicaid and Social Security.

What this means for your portfolio

What, then, are the key takeaways for investors?

First, it is important to watch the data. A softening economy need not lead to recession. But, at the same time, complacency is unwise. In our opinion, something is afoot. And the Fed’s job is now more difficult. Inflation remains too high for its liking, and as growth becomes less predictable, so too does US monetary policy. Consequently, the risk of policy error increases.

Second, we believe it is possible to manage the risk of economic weakness. Risk management begins with proper portfolio analysis, including reviews of liquidity needs. Selling into market setbacks can potentially be avoided by making decisions today to balance return and liquidity objectives. 

Third, it is possible to diversify the risk of economic weakness. If the economy continues to slow, we believe longer maturity Treasury and high-quality corporate bonds will likely perform well, offsetting potential drawdowns in equity and commodity markets. Select areas of high yield and private credit also offer supportive income, in our analysis.

Finally, we remain strong believers that returns across equity markets should continue to broaden, as they have so far this year. Diversifying beyond the “Magnificent Seven”¹⁰ and outside the US markets has become more essential than ever. Fiscal stimulus in Europe and China, for example, offers scope for regional market returns to decouple.