Abstract
We investigate the role of domestic and international economic uncertainty in the cross-sectional pricing of UK stocks. We consider a broad range of financial market variables in measuring financial conditions in order to obtain a better estimate of macroeconomic uncertainty compared to previous literature. In contrast to many earlier studies using conventional principal component analysis to estimate economic uncertainty, we construct new economic activity and inflation uncertainty indices for the UK using a time-varying parameter factor-augmented vector autoregressive (TVP-FAVAR) model. We then estimate stock sensitivity to a range of macroeconomic uncertainty indices and economic policy uncertainty indices. The evidence suggests that economic activity uncertainty and UK economic policy uncertainty have power in explaining the cross-section of UK stock returns, while UK inflation, EU economic policy and US economic policy uncertainty factors are not priced in stock returns for the UK.
Highlights
Introduction and Literature ReviewOur study investigated the role of economic uncertainty in stock returns in an asset pricing framework
If UK stocks were exposed to economic uncertainty risk and if this risk were systematic, i.e., difficult to diversify, investors would require a premium for holding economic uncertainty sensitive stocks
Our study examined the pricing of macroeconomic uncertainty, which was assessed by two factors in our study: economic activity uncertainty and inflation uncertainty
Summary
Our study investigated the role of economic uncertainty in stock returns in an asset pricing framework. The IMF (2012, 2013) suggest that economic recessions during the period 2007–2009 and slow recoveries thereafter partly resulted from uncertainty about US and European monetary, fiscal and regulatory policies (see Bake et al 2016). We were interested in examining investors’ required rates of return on assets of varying sensitivity to uncertainty in response to this shifting economic uncertainty over time. We examined stocks’ sensitivity to economic uncertainty and studied whether this sensitivity, or uncertainty risk, plays a role in predicting the future cross-section of stock returns in the UK
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