The Role of Economic Uncertainty in UK Stock Returns

Sheng Zhu,Niall O’Sullivan,Meadhbh Sherman,Jun Gao

doi:10.3390/jrfm12010005

Abstract

We investigated the role of domestic and international economic uncertainty in the cross-sectional pricing of UK stocks. We considered a broad range of financial market variables in measuring financial conditions 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 constructed new economic activity and inflation uncertainty indices for the UK using a time-varying parameter factor-augmented vector autoregressive (TVP-FAVAR) model. We then estimated 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

Introduction and Literature Review

Our study investigated the role of economic uncertainty in stock returns in an asset pricing framework. There is some theoretical and empirical evidence that time variation in the conditional volatility of the unpredictable component of a wide range of economic indicators, i.e., macroeconomic shocks, is related to asset returns (Gomes et al 2003; Bloom 2009; Jurado et al 2015) Motivated by this aforementioned evidence, Bali et al (2016) quantified a macroeconomic uncertainty risk factor for the US stock market using the macroeconomic uncertainty index of Jurado et al (2015). The positive and highly significant spread between the alphas of the lowest and highest uncertainty beta portfolios suggests that: (i) the macroeconomic uncertainty risk factor has predictive power in the cross-sectional distribution of future US stock returns; (ii) when making investment decisions, the uncertain events of the future asset return distribution are considered as well as the mean and variance of the asset returns; and (iii) uncertainty-averse investors demand a risk premium when holding stocks with negative uncertainty beta.

Data and Variable Definitions

Market Portfolio and Risk Factors

Economic Policy Uncertainty Indices

Empirical Results

Conclusions