Historical geopolitical risk and the behaviour of stock returns in advanced economies

Abstract

In this study, we investigate the impact of global geopolitical risk (GPR) of different forms on the economies of advanced countries (G7 and Switzerland). We construct a predictive model, following the approach of Lewellen (2004. “Predicting returns with financial ratios.” Journal of Financial Economics 74 (2): 209–235) and Westerlund and Narayan (2012. “Does the choice of estimator matter when forecasting returns?” Journal of Banking & Finance 36 (9): 2632–2640; 2015. “Testing for Predictability in Conditionally Heteroskedastic Stock Returns.” Journal of Financial Econometrics 13 (2): 342–375), to analyse over a century of GPR indices and stock returns. For robustness, we control for oil price given its strong connection with stock returns of advanced economies and further extend our analysis to out-of-sample predictability. Our findings reveal that GPR is a significant predictor of stock returns in advanced economies, although their stock markets are vulnerable to GPR and particularly suffer greater adverse effects from threats of GPR (such as threats of war and terrorism) than their actual occurrence. Meanwhile, our forecast evaluation results show that the predictive model that accommodates the GPR indices outperforms the benchmark model that ignores the same both in the in-sample and out-of-sample forecast estimates.