Economic policy uncertainty and stock market returns: Evidence from Canada

Abstract

We contribute to the literature on economic policy uncertainty (EPU) and asset prices by studying the impact that EPU has on the behavior of the stock market in Canada over the period 1985–2015. Even though a previous study has assessed the impact of policy uncertainties on stock returns in Canada, no research has explained its country-specific associated implications about policy and market behavior in short-run and long-run. Our results indicate that the EPU exhibits significant negative impacts on Canadian stock market returns in both OLS and ARDL estimations. When we look at the possibilities of asymmetric effects of EPU shocks through nonlinear adjustment of the policy uncertainty measure, we find both short-run and long-run impacts are asymmetric. In the long-run, increased policy uncertainty persuades investors to take a ‘risk-off’ approach to gravitate toward lower-risk investments, which tends to decrease asset prices, whereas, decreased uncertainty prompts investors to take on portfolio risk for the chance of higher returns. Over the long-run, higher inflation can have a dampening effect on investment returns and real savings. The Bank of Canada should always demonstrate its accountability through forward looking monetary policy actions to maintain the value of assets in the long-run. Our main conclusions are based on various robustness checks.