Can economic policy uncertainty predict stock returns? Global evidence

Abstract

This paper, using data for 16 countries, tests whether economic policy uncertainty (EPU) predicts stock excess returns. First, we show that the ability of EPU to forecast stock returns depends not only on the country used, but also on the sectors examined. This indicates that forecasting of returns is country-dependent (sector-dependent), suggesting that EPU is relatively more important for some countries (sectors) than others. Second, we test whether the predictability of EPU is from either or both the cash flow and discount rate channels. Our results support the discount rate channel over the cash flow channel. Third, we use positive and negative EPU shocks to predict stock excess returns and find evidence of asymmetric predictability. Finally, we consider a mean–variance investor and show that such investor has positive utility by following forecasts generated from the EPU-based model. Our results are consistent with a number of robustness tests.