Accepted Manuscript

Can Economic Policy Uncertainty Predict Stock Returns? Global Evidence

Dinh Hoang Bach Phan, Susan Sunila Sharma, Vuong Thao Tran

PII: S1042-4431(17)30178-6
DOI: https://doi.org/10.1016/j.intfin.2018.04.004
Reference: INTFIN 1041

To appear in: Journal of International Financial Markets, Institu-

tions & Money

Received Date: 10 April 2017

Accepted Date: 5 April 2018

Please cite this article as: D.H.B. Phan, S.S. Sharma, V.T. Tran, Can Economic Policy Uncertainty Predict Stock
Returns? Global Evidence, Journal of International Financial Markets, Institutions & Money (2018), doi: https://
doi.org/10.1016/j.intfin.2018.04.004

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 Can Economic Policy Uncertainty Predict Stock Returns? Global Evidence

Dinh Hoang Bach Phan, Susan Sunila Sharma, and Vuong Thao Tran

Mailing Address

Susan S Sharma
Deakin Business School
Faculty of Business and Law
Deakin University
221 Burwood Highway, Burwood
Victoria 3125, Australia
Telephone: +61 3 9244 6871
Fax: +61 3 9244 6034
Email: s.sharma@deakin.edu.au

Corresponding Author:

Susan Sunila Sharma

Department of Finance & Centre for Financial Econometrics Deakin Business School Faculty of
Business and Law Deakin University
221 Burwood Highway, Burwood
Victoria 3125, Australia
Telephone: +61 3 9244 6871
Fax: +61 3 9244 6034
Email: s.sharma@deakin.edu.au

Dinh Hoang Bach Phan

Taylor's Business School, Faculty of Business and Law, Taylor's University, Malaysia
Department of Accounting and Finance, School of Business, Monash University, Malaysia

Vuong Thao Tran

Department of Accounting and Finance, School of Business, Monash University, Malaysia

1
 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.

Keywords: Stock returns; Economic Policy Uncertainty; Predictor; Investor Utility.

2
1. Introduction

This paper examines the role that economic policy uncertainty (EPU) plays in predicting stock

excess returns. There is a growing literature (see, e.g., Li et al., 2016; Kang and Ratti, 2013;

Kang et al., 2017) that investigates the link between EPU and financial markets. The main

evidence suggests that EPU has a negative effect on stock returns.1 Our aim is to complement

this literature by testing the predictive power of EPU. We propose the following hypothesis:

EPU predicts international stock returns.

The motivation behind our hypothesis is that EPU, which is defined as uncertainty

regarding fiscal, regulatory, or monetary policy (Brogaard and Detzel, 2015), has an influence on

a number of financial and economic fundamentals. The popularity of the EPU measure is

reflected in recent studies that investigate the effect of EPU on inflation and output (Jones and

Olson, 2013), unemployment (Caggiano et al., 2017), economic development (Scheffel, 2015),

monetary policy effects (Aastveit et al., 2013), real housing returns (Christou et al., 2017),

commodity markets (Wang et al., 2015), exchange rate expectations (Beckmann and Czudaj,

2016), corporate governance (Zhang et al., 2015), corporate investment (Wang et al., 2014),

stock and bond market correlation (Li et al., 2015), co-movement of stock markets (Li and Peng,

2017), stock market volatility (Liu and Zhang, 2015), financial stress (Sun et al., 2016), and

sources of global stock market risk (Tsai, 2017). The key message from these studies is that EPU

has a significant impact on both economic fundamentals as well as stock market performance.

Within this body of literature, studies that focus on the EPU–stock return nexus are

scarce. Li et al. (2016) show that stock market performance can be negatively affected by EPU in

the sense that uncertainty in economic policies cause participants to harbor pessimistic

1
Brogaard and Detzel (2015) document that the level of EPU has a positive effect on stock returns, but the change
in EPU shock has a negative effect on stock returns.

3
considerations about expected future dividends and/or discount rates, which may lead to a drop

in share prices. Additionally, using state probabilities estimated from two-state regime-switching

models of aggregate stock market returns, Ozoguz (2009) discovers a negative link between

stock returns and economic uncertainty. Pástor and Veronesi (2012) measure government policy

uncertainty as the variance of policy change and conclude that it negatively affects stock returns.

Several papers document that an increase in EPU leads to lower stock returns in the U.S. market

using several models, namely, vector autoregression (VAR) (Kang and Ratti, 2013; Kang et al.,

2017), dynamic conditional correlation (DCC) (Antonakakis et al., 2013), the quantile regression

approach (Bekiros et al., 2016), and linear and nonlinear Granger causality tests (Ajmi et al.,

2015).

Moreover, the literature in the context of European countries (Gao and Zhang, 2016;

Demir and Ersan, 2016), China (Yang and Jiang, 2016; Kang and Ratti, 2015; Li et al., 2016),

India (Bhagat et al., 2013; Li et al., 2016), and other international markets (Chuliá et al, 2017;

Ko and Lee, 2015; Lam and Zhang, 2014) also find a negative relationship between EPU and

stock market performance.

The literature shows that EPU does have a significant effect on economic fundamentals

and on stock market performance. Therefore, from an investor’s point of view, it is worth

investigating whether stock returns are predictable using EPU as a predictor variable and, more

importantly, whether this can lead to successful trading strategies. Our study is closely related to

Brogaard and Detzel (2015), Bekiros et al. (2016), and Huang et al. (2015). Brogaard and Detzel

(2015) use the measure from Baker et al. (2016) to capture EPU in the US to forecast log excess

market returns. These authors find that EPU significantly and positively forecasts excess market

returns. Bekiros et al. (2016) investigate whether EPU could help forecast the US-based equity

4
premium by accounting for structural instability and omitted non-linearity via a quantile

predictive regression model. Their findings reveal that EPU contains significant out-of-sample

information, especially when the market is neutral and has a slight upward trending behavior,

and not when the market appears highly bullish. The current state of the literature is that EPU is

statistically driven and that EPU either negatively or positively moves stock returns. On the other

hand, Huang et al. (2015) explain that once the predictor of stock returns is found to be

statistically significant, it is relatively important to understand the economic driving force of the

predictor variable; that is, to test whether the predictability comes from time variation in cash

flows or discount rates. Therefore, two specific components of this economic story are

important: (1) whether (and how) EPU has any economic value for stock market participants;

and (2) understanding predictability and understanding the source of this predictability are

equally important. Neither (1) nor (2) are fully understood with respect to the EPU–stock returns

nexus. By addressing both these issues, our paper fills an important gap in this literature.

While our paper is closest to Brogaard and Detzel (2015) and Bekiros et al. (2016)2, there

are important differences. First, we use historical monthly time series data for no fewer than 16

countries for which EPU data is available, while prior studies consider only the US market. Our

analysis therefore contributes to understanding the role of EPU beyond the US market. Second,

we consider not only country-specific EPU, but also global EPU to predict a country’s stock

market excess returns. This consideration matters, because previous studies (see, e.g., Dakhlaoui

2
It is worth noting that Bekiros et al (2016) examine the relation using quantile regression model while we utilise a
recent framework proposed by WN which is able to handle data that are persistent, endogeneous and
heteroskeasticy. Our dataset has these data features and appropriately modelling it offers a way of understanding the
relationship from a different econometric modelling perspective. Moreover, we do not estimate quantile regression
because of small sample and since quantile regression has already been done and doing so will not add anything
new.

5
and Aloui, 2016) show that economic and financial system shocks in one country may be

significantly transferred (whether directly or indirectly) to other countries. 3

Third, we consider both in-sample and out-of-sample predictability evaluations. We make

use of the Westerlund and Narayan (WN, 2015) predictability model, which not only accounts

for heteroskedasticity of the predictor variable, but also for persistency and endogeneity in the

variables, while Brogaard and Detzel (2015) consider only heteroskedasticity by using Hodrick

(1992) standard errors. Fourth, we explore evidence from out-of-sample evaluations, where we

compare the EPU-based stock return forecasting model with the historical average model. This is

important because the relative roles and, therefore, importance of in-sample versus out-of-sample

tests are a focus of the literature; basically, there is no consensus. Welch and Goyal (2008) hold

that a predictor must provide good out-of-sample predictive performance to be used by an

investor. These authors also believe that out-of-sample forecasting analysis would be more

appropriate than in-sample predictability for investors, as they are required to take decisions in

real time. In addition, Tashman (2000) claims that forecasting methods should be considered for

accuracy using out-of-sample tests rather than goodness-of-fit of past data (in-sample tests).4

Fifth, we explore stock return predictability at the sector level. Previous studies on the

effect of EPU on stock market returns focus only on the aggregate market level. The drawback of

investigating predictability at the aggregate market level is that it assumes that the predictability

3
A number of studies show that national stock markets are affected by global factors, such as global crude oil
(Driesprong et al., 2008; Cunado and Gracia; 2014), size, value, and momentum global risk factors (Chan et al.,
2000; Griffin et al., 2003; Fama and French, 2012), and the Global Financial Crisis (Tong and Wei, 2011; Bekaert et
al., 2014).
4
The out-of-sample analysis is favored over in-sample analysis because in-sample errors are likely to understate
forecasting errors for a given forecasting method. Tashman (2000) argues that the chosen in-sample predictive
model is aimed at predicting the historical data. Although the selected model provides the best in-sample fit, it may
not be ideal for an out-of-sample test, as the nuances of past history may not continue in the future, and the nuances
of the future may not have exposed themselves in the historical data. The literature on stock return forecasting shows
numerous predictors that are successful in in-sample predictability but fail in out-of-sample forecasting (for
example, Bossaerts and Hillion, 1999; Goyal and Welch, 2003; Welch and Goyal, 2008).

6
of sector stock returns is homogeneous, which implies that EPU has the same predictive ability

for all sectors. However, this is a strong assumption and is unlikely to be true, because studies

that undertake sectoral predictability tests in other strands of the literature show that some

sectoral returns are only weakly predictable or even unpredictable (Hong et al., 2007; Narayan

and Sharma, 2011; Narayan and Bannigidadmath, 2015; Phan et al., 2015b). The motivation for

testing predictability at the sector level also has roots in a dynamic asset pricing model (see

Rapach et al., 2011), and the implications such evidence of predictability (or otherwise) offer for

capital allocation among sectors and sector-rotation strategies in portfolio management (Kong et

al., 2011).

Sixth, we empirically test whether stock returns of the 16 countries in our sample are best

characterized by dividend yield forecasts (that is, discount rate channel) and/or dividend growth

(through cash flow channel) forecasts. There is a body of influential studies (Cochrane, 2008,

2011; Campbell, et al. 2010; and Huang et al., 2015) that explains the importance of empirically

examining the source of return predictability. It is argued that if stocks are priced by discounting

their cash flows at a rate that can be held constant over time, then stock price movements can be

attributed to news about cash flows. On the other hand, if discount rates are found to be time-

varying, then there is a possibility that the group of stocks can move together due to common

shocks to discount rates, rather than fundamentals (see Campbell et al., 2010 for more detailed

discussion). Therefore, stock return predictability can occur through the expected cash flow

channel, the discount rate channel, or both.

Seventh, we test the asymmetric predictive ability of EPU shocks, where we use positive

and negative EPU shocks as predictors of stock excess returns. Empirical evidence indicates that

shocks to the market can be categorized as positive or negative shocks. For instance, there is an

7
established literature that suggests that the effect of crude oil shocks is asymmetric (see

Sadorsky, 1999; Kilian and Park, 2009; Sim and Zhou, 2015; Phan et al., 2015a). More

importantly, we previously noted that Bekiros et al. (2016) conclude that the relationship

between stock returns and EPU is nonlinear, suggesting potentially asymmetric characteristics of

EPU shocks. In light of this empirical evidence, we test whether positive and negative EPU

shocks predict stock returns differently.

Finally, statistical forecasting performance measures are sometimes found not to be

sufficient from the perspective of the practitioner. In this regard, one issue is around how

investors can successfully trade by tracking information from EPU shocks. We remedy this by

utilizing forecast returns from the EPU-based model to devise a dynamic trading strategy for a

mean–variance investor. We compare the utility function of a mean–variance investor from the

EPU-based model with the historical average model.

Our paper offers the following new findings: (1) we find that country-specific (global)

EPU predicts stock excess returns for 8 (9) out of 16 countries; (2) our results reveal that the

source of return predictability is through the discount rate channel and less so through the cash

flow channel; (3) utility gains are found to be positive using our proposed EPU-based forecasting

model; (4) we document that stock return predictability is sector-dependent; and (5) there is clear

evidence of asymmetric predictability when we use positive and negative EPU shocks to predict

stock returns at aggregate market and sector levels.

Finally, we conclude with extensive robustness tests: (a) we consider different sets of in-

sample and out-of-sample periods; and (b) we consider different risk aversion factors of a mean–

variance investor. .

8
 The balance of this paper proceeds as follows. In Section 2, we discuss the contribution

of our study. In Section 3, we provide information on our data and empirical predictability

model. In Sections 4 and 5, we discuss the main findings and the robustness test results,

respectively. Finally, in Section 6, we set forth our concluding remarks.

2. Contribution

The contribution of our work is to the following bodies of literature. Our first contribution is to

the literature on stock return predictability. To date, numerous variables are used to predict stock

returns, including financial ratios and macro variables (see Campbell and Thompson, 2008;

Rapach et al., 2010; Gupta et al., 2014), oil price (Driesprong et al., 2008; Narayan and Sharma,

2011; and Sim and Zhou, 2015), US market returns (Rapach et al., 2013), technological

innovation (Hsu, 1999), credit standards (Chava et al., 2015), and EPU (Brogaard and Detzel,

2015; Bekiros et al., 2016). Our study contributes to the literature that uses EPU as a predictor of

stock returns, by showing that the predictability of stock returns using EPU as a predictor is

country-dependent. More specifically, using in-sample predictability tests, we find that country-

specific EPU negatively predicts stock market excess returns in the case of six countries:

Australia, Canada, Italy, Japan, South Korea, and the US, while global EPU is a statistically

significant predictor of stock excess returns for five countries: Canada, India, South Korea,

Japan, and the US. Moreover, we use a 50% estimation period to generate recursive forecasts of

excess returns for the remaining 50% of the sample. The out-of-sample evaluation statistics

reveal relatively strong evidence that our proposed EPU-based forecasting model beats the

historical average model regardless of whether we use global or country EPU. We comfortably

reject the null hypothesis that out-of-sample r-squared for 9 out of 16 countries.

9
 Additionally, we find evidence that not only country-specific EPU significantly predicts

country excess stock returns; global EPU also plays a crucial role in predicting a country’s stock

excess returns. The evidence on stock return predictability is found in more than 30% of

countries using the in-sample predictability test, while the out-of-sample evaluation reveals that

more than 56% of the countries lend support to our proposed global EPU-based forecasting

model over the benchmark historical average model.

Our second contribution is to the literature on the source of predictability, where studies

have generally found mixed evidence on the source of predictability through discount rate and

cash flow channels. The majority of studies support the discount rate channel. On the other hand,

the recent Huang et al. (2015) supports the cash flow channel. Therefore, we conclude that this

debate is ongoing. Our empirical analysis provides strong evidence that the source of return

predictability is through the discount rate channel and less so through the cash flow channel.

Our third contribution is to the literature on economic significance of stock return

forecasting models. A study on stock return predictability is considered incomplete and

irrelevant if one cannot make economic sense of the predictability model (see, for instance,

Driesprong et al., 2008; Narayan et al., 2013; Narayan and Sharma, 2014; Phan et al., 2015a,

2015b). In this regard, we utilize not only statistical measures of the out-of-sample predictability,

but also the economic significance of using EPU to predict stock returns. We show that mean–

variance investors can obtain positive utility gains from our forecasting models. 5 The annualized

utility gains in the case of country-specific and global EPU fall in the -0.18% to 3.43% and -

0.88% to 3.02% ranges, respectively. The utility gain is maximized for Japan and the US when

we consider country-specific and global EPU, respectively.

5
The utility gains can be interpreted as the portfolio management fee that an investor is willing to pay to have
access to the additional information offered in the EPU-based forecasting model.

10
 Our fourth contribution relates to the literature that documents the importance of

conducting empirical analysis at firm and sector levels rather than at the aggregate market level

(see, e.g., Phan et al., 2015b, Narayan and Sharma, 2011; Narayan et al., 2014). We consider this

to be important in light of the fact that different sectors have different degrees of dependence on

EPU shocks; thus, sectoral heterogeneity needs to be addressed. We repeat our empirical

analyses for 10 sector indexes in the US market. In-sample predictability is discovered in seven

(six) sectors using country (global) EPU, while out-of-sample predictability is found in six

sectors for use of either global or country-specific EPU. The utility gains for mean–variance

investors are positive in most cases and could be up to 6.25% per annum. We conclude that stock

return predictability is sector-dependent, suggesting that EPU has relatively stronger influence on

some sectors than others.

Our final contribution is to the literature that examines the asymmetric effect of positive

and negative financial/economic shocks on stock returns. Any kind of financial/economic shock

to the stock market can be perceived as a positive or negative shock. To date, there is no paper

that examines the positive and negative EPU shock—stock return nexus. Our paper is the first to

examine whether an increase or decrease in EPU shocks predicts stock excess returns of 16

countries and 10 US sectors, differently. In other words, we test for the null hypothesis of

“symmetric predictability effect” of EPU shocks. Overall, we find evidence of asymmetric

predictability using both global and country-specific EPUs. The predictive ability of positive and

negative EPU shocks are country and sector-dependent.

3. Data and Methodology

3.1. Data
Our sample involves two sources of data—EPU and stock returns. We use the EPU measure of

Baker et al. (2016). This measure is found to be a good proxy for real-world economic policy

11
uncertainty and is used widely (Wang et al., 2014; Ajmi et al., 2015; Li et al., 2016; Li and Peng,

2017).6 The time series of EPU indexes are obtained from their website, 7 which provides EPU

indexes for the globe and 16 countries: Australia, Brazil, Canada, China, France, Germany,

India, Ireland, Italy, Japan, South Korea, the Netherlands, Russia, Spain, the United Kingdom,

and the United States. We consider both EPU from individual countries and global EPU to

predict stock excess returns. EPU shocks are computed as changes in the EPU indexes. Our

second data set consists of monthly excess stock index returns of 16 countries. 8 Only countries

that have EPU data are selected. The list of stock market indexes of each country is reported in

Table I. All stock data are obtained from the Datastream database. The monthly sample period

for each country differs and is conditional on data availability. The sample size ranges from 160

observations for the Netherlands to 378 observations for Canada, Ireland, and the US. The

specific start date for each country is given in Column 2 of Table II, and the end date is identical

for all countries, June 2016. In Figure I, we provide plots of stock market excess return and the

EPU series for all 16 countries.

INSERT FIGURE I

INSERT TABLE I

3.2. Methodology
Following the literature on stock return prediction, the predictive regression model with EPU

treated as a predictor of stock returns can be written as:

(1)

6
The uncertainty index is constructed from three types of underlying components: newspaper coverage of policy-
related economic uncertainty, federal tax code, and disagreement among economic forecasters. Higher value of the
index represents greater economic policy uncertainty.
7
http://www.policyuncertainty.com
8
The stock index excess returns are the difference between the stock index return and three-month treasury bill rate
for each country. The three-month Treasury bill rates of each country are downloaded from the Global Financial
Database.

12
where is stock index excess returns in month t, and is EPU in month t-1. This model

is simple to estimate but has a number of drawbacks, as it potentially suffers from issues of

persistency, endogeneity, and heteroskedasticity. The bias and inefficiency of the predictor

coefficient resulting the aforementioned issues are discussed in Stambaugh (1999), Lewellen

(2004), and Westerlund and Narayan (2012, 2015). Assume the predictor in Equation (1) follows

an AR (1) process, as follows:

(2)

(3)

where ≤ 1. and are independently and identically distributed disturbance terms and are

assumed to have mean zero and to be uncorrelated with each other (which means = 0).

Unfortunately, this assumption does not always hold, which renders the predictor endogenous.

As a consequence, the OLS estimator of β is no longer unbiased. In addition, predictors can be

highly persistent. Lewellen (2004) proposes a bias-adjusted estimator that can take into account

the bias inherent from persistency and endogeneity in the OLS predictive regression model.

However, the heteroskedasticity issue remains, which is an efficiency problem.

To address these three issues in the predictive regression, we apply the feasible

generalized least squares (FGLS) estimator recently developed by Westerlund and Narayan

(2015),9 which enables the testing of predictability while, at the same time, accounting for

information from the heteroskedasticity of the predictor and the regression error. The FGLS

9
This model is popular and has been used extensively in the predictability literature (see Phan et al, 2015b; Narayan
and Gupta, 2015, Narayan and Bannigidadmath, 2015; Narayan, Sharma, and Thuraisamy, 2015; Narayan and
Sharma, 2015; Bannigidadmath and Narayan, 2015; Narayan, Phan, Thuraisamy, and Westerlund, 2016; Devpura,
Sharma, and Narayan, 2017; Narayan, Phan, Narayan, and Bannigidadmath, 2017; Narayan, Phan, and Sharma,
2017; Sharma, 2017)

13
estimator of proposed by Westerlund and Narayan (2015) is based on an augmented version of

Equation (1), and has the following form:

(4)

where is the adjusted slope coefficient, which can be the bias-adjusted

estimator introduced by Lewellen (2004); it can be estimated simply by applying OLS to

Equation (4). Westerlund and Narayan (2015) assume that , where c ≤ 0 is a drift

parameter that measures the degree of persistency in . If c = 0, then the predictor has an

exact unit root, and if c < 0, the predictor is stationary in the sense that approaches 1 as T

increases. Therefore, FGLS does not need the assumption that the predictor is stationary, while

Lewellen (2004) does, which is quite restrictive. FGLS includes the information contained in the

ARCH structure of the error terms, which is ignored in the Lewellen (2004) model. Westerlund

and Narayan (2015) provide further detailed explanation on the computation of .

4. Empirical Results

4.1. Preliminary results

We begin by discussing the common descriptive statistics of stock market excess returns

and our predictor variable, EPU shocks, for the globe and for the respective 16 countries in our

sample. The results are reported in Table II. Considering the evidence for stock market excess

returns, we note that the monthly mean ranges from as low as -0.049% in the case of Australia

to as high as 3.575% for Brazil. By comparison, the most volatile stock market excess returns,

based on the standard deviation, is experienced by Russia and Brazil, while Australia

experiences the least volatility. The first-order autoregressive coefficients for each country’s

excess returns are less than 30%, except in the case of Brazil (less than 50%), suggesting that

14
shock persistence is low. Additionally, except for Canada, China, India, Italy, South Korea, and

Russia, the remaining countries are all characterized by strong ARCH effects, that is, the null

hypothesis of “no ARCH” is rejected for these remaining 10 countries.

We now turn to the last six columns of Table II, where we report descriptive statistics of

the predictor variable, the EPU shocks. From the mean and standard deviation statistics, we

observe how the EPUs for 16 countries are likely to differ. Specifically, the monthly means

range from 0.02 index points (Netherlands) to 3.18 index points (UK). The EPU for Russia is

most volatile and the EPUs for Japan and the US are least volatile. Additionally, we find that the

first-order autoregressive coefficient for EPU is less than 50% for all 16 countries, suggesting

that shock persistence is low. Next, we reject the null hypothesis of “no ARCH” for 11

countries, which indicates the EPUs for those 11 countries (except for Canada, China, India,

Italy, and Spain) are characterized by strong ARCH effects.

INSERT TABLE II

Table III reports unconditional correlation between excess return and one period lagged

EPU. We not only consider the unconditional correlation between country-specific EPU and

excess returns (see Columns 2 & 3), but we also check the unconditional correlation between

global EPU and the excess returns of 16 countries (see Columns 4 & 5). The former is

statistically significant for five countries (namely, Australia, Canada, Italy, Japan, and South

Korea), while the latter is statistically significant for all 10 countries (except China, France, Italy,

and Spain).

INSERT TABLE III

15
 As a final preliminary, we test for any evidence that our predictor variable is endogenous.

The results are reported in Table IV. Again, results are reported for the country-specific EPU

(see Columns 2 & 3) and the global EPU (see Columns 4 & 5). We find that the country-specific

EPU is endogenous for all 15 countries except Ireland, whereas the global EPU is endogenous

for all 16 countries.

INSERT TABLE IV

4.2.In-sample Predictability

Results based on in-sample predictability test are reported in Table V. These results are reached

using both country-specific and global EPU as predictors of market excess returns. We report the

coefficient of the FGLS test and the t-statistics associated with the null hypothesis of “no

predictability” for both predictors. When we consider country-specific EPU as a predictor of

excess return, we find that there is evidence of predictability for only six countries: Australia,

Canada, Italy, Japan, South Korea, and the US. Global EPU can predict excess returns for only

five countries: Canada, India, South Korea, Japan, and the US. Note that for three countries,

Canada, Japan, and South Korea, both country-specific and global EPU can predict excess

returns.10

INSERT TABLE V

4.2 Out-of-sample predictability

This subsection reports out-of-sample evaluation of the importance of predictors in

forecasting excess returns vis-à-vis the constant returns model. A 50% in-sample period is used

10
We have also conducted in-sample predictability test by including dividend yield in the model. We do not have
data on dividend yield for 6 countries (namely, China, Germany, Ireland, Japan, South Korea, and Russia) and
therefore, we could not produce results for these 6 countries. We do not report these results in the paper due to
space constraint. The results are available upon request from the authors. We find that our results do not change
when we include dividend yield in the predictive regression model.

16
to generate recursive forecasts of excess returns for the remaining 50% of the sample. We report

the out-of-sample -squared ( ), which examines the difference in the mean squared errors

from the competition model and the constant returns model in Table VI. The Clark and West

(2007) MSFE-adjusted test statistic, denoted with an asterisk, examines the null hypothesis that

against the alternative that . Consider first the country-specific EPU as a

predictor of excess returns based on the null hypothesis that ; the null is rejected for 9

(Australia, Canada, Germany, India, Ireland, Japan, South Korea, the UK, and the US) of the 16

countries. is positive, suggesting that a forecasting model that uses country-specific EPU

to forecast excess returns beats the constant returns model. In the next set of forecasting models,

where we use global EPU as a predictor, we comfortably reject the null hypothesis again for 9

(Canada, Ireland, Italy, Japan, South Korea, Netherlands, Russia, Spain, and the US) out of 16

countries. Again, we find the coefficients are positive, suggesting that the global EPU-based

predictor model outperforms the constant returns model.

INSERT TABLE VI

The main findings that emerge from in-sample and out-of-sample predictability tests are

as follows. First, we find that for five countries (Canada, Ireland, Japan, South Korea, and the

US), both country-specific and global EPU-based predictor models outperform the constant

model. Second, both in-sample and out-of-sample predictability tests provide consistent results

for four countries, Canada, Japan, South Korea, and the US. Finally, we reject the null

hypothesis of no predictability for 10 out of 16 countries when we consider country-specific

(except for Brazil, China, France, Netherlands, Russia, and Spain) and global EPU (except for

Australia, Brazil, China, France, Germany, and the UK) as predictors of excess return.

17
4.3 Source of predictability

In this subsection, we investigate the source of predictability for those countries where we find

evidence of predictability using both in-sample and out-of-sample predictability tests. According

to valuation models, stock prices are determined by both future expected cash flows and discount

rates. Baker and Wurgler (2006,2007) argue that the ability of investor sentiment to forecast

aggregate stock market returns may come from either or both the cash flow and discount rate

channels. Therefore, it is imperative to investigate this issue. This means that we need to

investigate whether the predictability of EPU is from either or both channels. Consistent with the

literature (see, e.g., Cochrane, 2008; 2011; Campbell et al., 2010; Huang et al., 2015), we use log

aggregate dividend price ratio and log aggregate dividend growth rate as proxies for discount rate

channel and cash flow channel, respectively. Inspired by Campbell and Shiller (1988), our future

aggregate stock market return takes the following form:

where, is aggregate stock market return from time to , is log aggregate dividend

growth rate, is log aggregate dividend price ratio, and is a positive log-linearization

constant. The implication of Equation (6) is that if EPU predicts next-period market return

beyond the information contained in , it must predict either log aggregate dividend growth

rate or log aggregate dividend price ratio (or both). More simply, if, for instance, EPU predicts

both and , this suggests that the source of predictability is from both the cash flow

and the discount rate channels. Thus, our predictive regression model takes the following form:

18
 The results obtained from Equation (7) are reported in Table VII. First, we read results

from Column 2 of Table VII. Of the countries for which country-specific EPU predicted stock

market excess returns, for four countries, there is statistically significant evidence on the source

of predictability. Note that EPU predicts DP for Australia, India, Ireland, and Japan. In the case

of Japan, EPU is also able to predict DG. These results suggest that for Australia, India, and

Ireland, EPU predicts stock returns through the discount rate channel only, whereas for Japan,

EPU predicts Japan’s stock market returns through both cash flow and discount rate channels.

INSERT TABLE VII

On the other hand, when we use global EPU as a predictor of stock excess returns, we

find that global EPU can predict DP for five countries: India, Ireland, South Korea, Netherlands,

and the US. Of these nine countries (where we find evidence of significant predictability), global

EPU also predicts DG for four countries (India, Japan, Russia, and the US). The results based on

global EPU imply that for Ireland, South Korea, and the Netherlands on one hand, and Japan and

Russia on the other, the source of predictability is through the discount rate and cash flow

channels, respectively. Only for India and the US is the source of predictability from both cash

flow and discount rate channels. Overall, our results suggest that discount rate channels are

relatively more important compared to cash flow channels in explaining stock return

predictability.

4.4 Economic significance

The literature (see, e.g., Rapach et al., 2010; Campbell and Thompson, 2008) recommends using

a utility-based measure of economic significance, due to the fact that the does not account

for investor risk aversion over the out-of-sample period. Therefore, in this subsection, we

provide results on utility for a mean–variance investor on a real time basis. A mean–variance

19
investor has the following utility function: , such that for a given

portfolio weight of for the risky asset, the utility simply becomes:

where is the excess return on stocks, is the risk-free rate of return, is the rolling

variance of the risky asset, is the risk aversion factor, and is the investor’s portfolio

weight in period , computed as: .

Apart from restricting the portfolio weight to between 0 and 1, we also constrain the

portfolio weight on stocks to between -0.5 and 1.5, representing an investor who undertakes

short-selling and borrowing of up to 50%. The average utility level, ex post, becomes:

To generate the utility gain, we need to have a forecast of returns and their variance. We

use 50% of the sample as an in-sample period and generate recursive forecasts of excess returns

for the remaining 50% of the sample. We use a 60-month rolling window of returns to compute

variance. Portfolio weight is used to decide the proportion of each dollar to be invested in the

risky asset (the stock market) and the risk-free asset (the three-month T-bill rate). Two

assumptions are made for the purpose of mean–variance investor setup: (i) investors use only

public information to forecast one-period-ahead excess returns; and (ii) since we use monthly

data, investors rebalance their portfolios once a month. Thus, the utility gains are the difference

between the utility from a trading strategy based on our proposed EPU-based model and the

benchmark historical average model. The utility gains are annualized. Note that the utility gains,

because they depend on forecast returns, are estimated only for those 10 countries for which

20
predictability was found (using both country-specific and global EPU as predictors of excess

returns). The average utility gains for each country based on each predictor are reported in Table

VIII.

We begin with utility gains based on a portfolio weight that is restricted to between 0 and

1, , implying that there is no short-selling or borrowing, and also when we consider a risk

aversion factor equal to 6. When we consider the country-specific EPU, the utility gains are all

positive except for Australia, whereas, for the global EPU, the utility gains are all positive except

for Italy. The annualized utility gains for country-specific and global EPU fall in the -0.18% to

3.43% and -0.88% to 3.02% ranges, respectively. For country-specific and global EPU, the

utility gain is maximized for Japan and the US, respectively. In addition, we report results based

on 50% short-selling and borrowing, . The results are broadly consistent with those

observed without allowing for short-selling and borrowing. Also note that the utility gains are

maximized for a mean–variance investor when 50% short-selling and borrowing is allowed.

INSERT TABLE VIII

4.5 Additional Results

4.6.1. Sector-level analysis

In this subsection, we repeat our analyses for 10 sectors in the US market11 categorized by the

Global Industry Classification Standard (GICS) from the Datastream database. The results for in-

sample predictability, out-of-sample predictability, and utility gains are reported in Panels A, B,

and C of Table IX, respectively. When we use the country-specific (US) EPU as the predictor,

evidence of in-sample predictability is exposed in seven sectors, namely, consumer goods,

11
Due to space constraints, we report only sectoral results for the US. Sector-based results are also presented for the
other 15 countries, which are available upon request. The main finding based on sector level results is that
predictability and economic significance are sector-dependent for all 16 countries.

21
consumer services, financials, healthcare, industrials, oil & gas, and telecommunications. The

results based on the global EPU predictor are slightly weaker as the statistically significant

coefficients of predictors are found only in five sectors. When we consider out-of-sample

statistical evaluations, is positive and statically significant in six sectors regardless of the

type of EPU used as the predictor of sectoral excess return. Additionally, using information from

an EPU-based forecasting model to construct trading strategy, mean–variance investors can earn

additional profits compared to employing the historical average model. The utility gains are

positive in 28 out of 30 cases and their magnitudes vary from 0.51% to 6.25% per annum.

Our main findings from exploring stock return predictability at the sector level are: (1)

predictability (whether in-sample or out-of-sample) and economic significance are sector-

dependent; (2) sectors are influenced by EPU differently, suggesting that EPU is more important

for some sectors than others; (3) EPU is unable to predict stock returns of the basic materials and

utility sectors.12

INSERT TABLE IX

4.6.2 Positive and negative EPU shocks

It is worth nothing that EPU shocks can have an asymmetric effect on stock returns. Thus far, no

study has tested the asymmetric effect of EPU shocks on the performance of stock markets. The

recent Li et al. (2015), which examines the effects of EPU shocks on stock–bond correlations for

12
As per one of the reviewers suggestion, we have also conducted in-sample predictability test for return volatility
using both country specific and global EPU as predictor variables. Monthly standard deviation is used as a proxy for
return volatility. We have used standard deviation of daily returns to compute monthly standard deviation. We find
that the country specific EPU significantly predicts return volatility of ten countries (namely, Australia, Canada,
Germany, India, Italy, Japan, South Korea, Netherlands, Spain and the UK). On the other hand, the global EPU is
statistically significant in the case of 13 countries (namely Australia, Brazil, Canada, France, Germany, Ireland,
Italy, Japan, South Korea, Netherlands, Spain, UK, and the USA). Just to note that in-sample predictability test
results for return volatility are not reported in this paper but detailed results are avialbale upon request from the
corresponding author.

22
the US market, distinguishes a positive shock from a negative one and finds evidence of

asymmetric impact of EPU on stock–bond correlations. Additionally, the most common shock

asymmetrically examined in the finance literature is oil price shock. To date, a number of studies

document that oil price shocks (positive and negative shocks) have asymmetric effects on stock

market returns (see, e.g., Sadorsky, 1999; Kilian and Park, 2009; Arouri, 2011; Sim and Zhou,

2015; Phan et al., 2015a; Reboredo and Ugolini, 2016). We borrow this idea from the oil price

shock literature and differentiate EPU shocks into positive and negative EPU shocks. The EPU

shock is measured as the change of EPU index, which can be either positive or negative. We

decompose the EPU shock to positive EPU shock, which is when the difference of EPU index is

positive; and negative EPU shock, which is when the difference of EPU index is negative. The

positive EPU shock indicates increase in the EPU shock while negative EPU shock implies

decrease in the EPU shock.

The rational for testing asymmetric effect of EPU shocks on stock returns originates from

the economic theory. According to the economic theory, that rising uncertainty may decrease the

economic activity given firms postpone their investments and hiring while consumers postpone

their purchases. What we note from the economic theory is that when uncertainty decreases, the

economic activity increases. This is more evident if there is pent-up demand for investment or

hiring after a period of high uncertainty. However, it is also worth noting that theory doesn’t

necessarily dictate the speed of the increase. In other words, theory does not necessarily predict

the magnitude of the effect. Foerster (2014) and Jones and Enders (2016) document that

increases and decreases of uncertainty may affect investment decisions in different ways. Large

increases may cause firms to postpone hiring and investing, consumers to postpone purchases,

23
and the economy to slow. On the other hand, economic activity increases followed by a large

decrease in uncertainty but not necessarily all at once, as firms and consumers adjust slowly.

In light of our empirical analysis, we test whether positive and negative EPU shocks predict

stock market excess returns differently. In the present study, positive EPU shock is defined as

, which indicates increase in the EPU shock, and negative shock is

, which implies decrease in the EPU shock.

The results based on predictability of stock excess returns using positive and negative

EPU shocks are reported in Table X. In Panel A of Table X, we report results based on all 16

countries. Again we use both positive and negative country-specific (see Column 2) and positive

and negative global EPU shocks (see Column 3) to predict stock excess returns. The main results

are as follows. Beginning with Italy, Japan, South Korea, and the US, we find that both the

increase and decrease in country-specific EPU shocks can statistically significantly predict stock

excess returns. However, the magnitude of positive and negative EPU shocks differs. Note that

the magnitude of positive shock is greater than the magnitude of the negative shock in predicting

stock returns. Thus, we still conclude that for these four countries, we do find evidence of

asymmetric predictability. Additionally, in the case of three countries, Australia, Canada, and

Ireland, we note that only a decrease in the EPU shock can significantly predict stock excess

returns. Next, we examine the results using the global EPU shocks. We find relatively strong

evidence of asymmetric predictability of excess returns using positive and negative EPU shocks.

We find that for six countries (Canada, China, France, India, Italy, and the US), an increase in

EPU shocks can significantly predict stock excess returns. In other words, for these six countries,

we comfortably reject the null hypothesis of a “symmetric effect.” Additionally, for two

countries (South Korea and the Netherlands), we find that both positive and negative EPU

24
shocks can significantly predict stock excess returns, however the magnitudes of the predictors

differ. This is again evidence of the existence of asymmetric predictability of EPU shocks.

INSERT TABLE X

Moreover, in Panel B of Table X, we report the asymmetric effect of EPU shocks on 10

US sectoral returns. The main conclusion from these sectoral results is that the country-specific

EPU shocks provide relatively stronger evidence of asymmetric predictability of stock excess

returns. We find the existence of asymmetric predictability using country-specific EPU in 6 of 10

sectors (consumer goods, consumer services, financials, industrials, telecommunications, and oil

& gas). Out of these six sectors, the excess returns of four sectors (consumer services, financials,

industrials, and oil & gas) are predictable using both an increase and a decrease in the country-

specific EPU; however, the magnitude of positive and negative EPU shocks are not equal. For

consumer services and industrials, the magnitude of negative EPU shock is greater than the

positive EPU shock, whereas for financials and oil & gas, the positive EPU shock matters more

than the negative EPU shock. On the other hand, when we consider global EPU, asymmetric

predictability is found only for the consumer goods, financials, industrials, and oil & gas sectors.

We find that only an increase in global EPU can significantly predict stock excess returns of

these four sectors. Overall, we conclude that the evidence of asymmetric predictability is sector-

dependent.

5. Robustness Tests

In this section, we undertake robustness test analysis of the results. First, we examine out-of-

sample predictability for all 16 countries using short (30%) and long (70%) in-sample periods.

We report the results in Table XI. When we consider a 30% in-sample period (see Panel A), our

25
findings are broadly consistent with those obtained when using a 50% in-sample period. is

positive and statistically significant for 10 countries, irrespective of the type of predictor (global

or country-specific) used for the analysis.

Next, we read results from Panel B of Table XI, where we consider a 70% in-sample

period. The evidence of positive and statistically significant is slightly weaker compared

to the results obtained using 50% and 30% in-sample periods. However, is positive and

statistically significant in the case of six countries (Canada, China, Ireland, Japan, the UK, and

the US) and three countries (Italy, Japan, and the Netherlands) when we consider country-

specific and global EPU, respectively. Overall, we find that there is strong evidence of

predictability for Canada, Japan, and South Korea, followed by Ireland, Italy, the Netherlands,

Russia, the UK, and the US, irrespective of the type of predictor and the in-sample period used

for our analysis.

INSERT TABLE XI

The second set of robustness tests includes testing investor utility using different risk

aversion factors. We report results using a risk aversion factor equal to 3 in Table XII. Our

approach in computing utility gains is the same as previously described (refer Section 4.5),

where we use a risk aversion factor equal to 6. Here, again, we drop those countries for which we

do not find evidence of predictability. More specifically, we compute utility gains by restricting

the portfolio weight to between 0 and 1, and by restricting the portfolio weight to

between -0.5 and 1.5, , for 10 countries where we find evidence of predictability.

The main outcome from these tests is broadly consistent with what we report in our main

findings in Section 4.3.

26
 INSERT TABLE XII

6. Concluding Remarks

This paper tests whether EPU can predict stock market excess returns. Our empirical analysis is

based on monthly data and covers 16 countries. We use a newly developed predictive regression

estimator that tests the null hypothesis of no predictability. In addition, we evaluate out-of-

sample forecasts on a pair-wise basis using the well-known statistic. Our proposed EPU-

based predictive regression model is compared with the constant return model. On the whole, we

find reasonable evidence that stock excess returns are predictable using EPU. More specifically,

we find strong evidence of predictability in 10 out of 16 countries when we use country-specific

(except for Brazil, China, France, the Netherlands, Russia, and Spain) and global EPU (except

for Australia, Brazil, China, France, Germany, and the UK) to predict excess returns.

Additionally, we examine, for those countries where stock returns are predictable using EPU as a

predictor variable, whether stock returns are best characterized by the discount rate channel

and/or the cash flow channel. We document that the bulk of the evidence on the source of

predictability supports the discount rate channel.

Next, we compute portfolio weights for investors on the assumption that they have a two-

portfolio asset, where one asset is risk-free and one is risky for those countries where we find

evidence of significant predictability. We compute utility gains for investors by using these

portfolio weights and appropriate restrictions to prohibit short-selling and borrowing, and to

allow for some level of short-selling and borrowing. We find that the utility gains are maximized

for a mean–variance investor when 50% short-selling and borrowing is allowed.

We repeat our analyses at the sector level for 10 sectors in the US market. We show that

the results for in-sample predictability, out-of-sample predictability, and economic significance

27
are sector-dependent. Different sectors are influenced by EPU differently, implying that EPU is

more important for some sectors than others. Two sectors, basic materials and utilities, are

affected neither by global nor US EPU.

Moreover, we test whether an increase and a decrease in EPU shocks predict stock excess

returns of 16 countries and 10 US sectors differently. Our analysis reveals that both country-

specific and global EPU show evidence of the asymmetric effect of EPU on stock excess returns.

Our robustness tests are as follows: (1) we use 30% (70%) in-sample periods to generate

recursive forecasts of excess returns for the remaining 70% (30%) of the sample to evaluate

the statistics and (2) we compute utility gains by allowing a risk aversion factor equal to

3. We conclude from our robustness check that, broadly, most of the robustness test results are

consistent with our main findings.

28
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 Figure I: Excess returns and economic policy uncertainty shocks
This figure plots stock market index excess returns and the economic policy uncertainty shock of 16 countries over the period January 1985 to June 2016.

Australia Brazil Canada China F rance

200 300 200 200 300

200 200
100 100
100
100 100
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0 0
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-100 -100 30
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0 0
-4 -10
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-8
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-16 -80 -30 -30 -30

1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 92 94 96 98 00 02 04 06 08 10 12 14 16 1985 1990 1995 2000 2005 2010 2015 96 98 00 02 04 06 08 10 12 14 16 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

E xcess return EPU E xcess returns EPU E xess returns EPU E xcess returns EPU E xcess returns EPU

G ermany India Ireland Italy Japan

400 200 300 150 100
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-200 0 0
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94 96 98 00 02 04 06 08 10 12 14 16 03 04 05 06 07 08 09 10 11 12 13 14 15 16 1985 1990 1995 2000 2005 2010 2015 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16

E xcess returns EPU E xcess returns EPU E xcess returns EPU E xcess returns EPU E xcess returns EPU

Korea South Netherlands Russia Spain United Kingdom

200 150 200 200 400

100 300
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0 0
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40 20 -50 50 20
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90 92 94 96 98 00 02 04 06 08 10 12 14 16 03 04 05 06 07 08 09 10 11 12 13 14 15 16 96 98 00 02 04 06 08 10 12 14 16 2002 2004 2006 2008 2010 2012 2014 2016 98 00 02 04 06 08 10 12 14 16

E xcess returns EPU E xcess returns EPU E xcess returns EPU E xcess returns EPU E xcess returns EPU

United States EPU Global

200 160

100 120

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10 -100 40

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0
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1985 1990 1995 2000 2005 2010 2015 98 00 02 04 06 08 10 12 14 16

E xcess returns EPU

38
 Table I: List of countries and stock indexes
This table reports details on specific market price index considered for each country.
Country Index
Australia All Ordinary Index
Brazil Brazil BOVESPA
Canada S&P /TSX Composite Index
China Shanghai Stock Exchange Composite
France France CAC 40
Germany FAZ General Index
India S&P BSE (Sensex) 30 Sensitive
Ireland Ireland Stock Exchange Overall
Italy FTSE MIB Index
Japan Nikkei 225 Stock Average
Korea South Korea Stock Exchange Composite
Netherlands AEX All Share
Russia Russia RTS Index
Spain Madrid Stock Exchange General
United Kingdom FTSE All Share
United States S&P 500 Composite

39
 Table II: Descriptive statistics
This table reports the selective descriptive statistics for stock market index excess returns and the economic policy uncertainty shock for the globe and 16
countries. The statistics include the mean value, standard deviation, AR(1), and ARCH(1). AR(1) refers to the autoregressive coefficient of order 1, while ARCH
(1) refers to a Lagrange multiplier test of the zero slope restriction in an ARCH regression of order 1 and the p-value of the test is reported.
Excess returns Economic policy uncertainty shock
Country Start date
Mean SD Skewness Kurtosis AR(1) ARCH(1) Mean SD Skewness Kurtosis AR(1) ARCH(1)
Australia Jan-98 -0.049 3.789 -0.923 4.234 0.096 0.000 0.525 43.010 0.316 5.019 -0.193 0.000
Brazil Jan-91 3.575 13.946 1.061 6.792 0.448 0.007 0.599 57.152 -0.182 4.918 -0.317 0.000
Canada Jan-85 0.082 4.318 -1.471 9.256 0.146 0.186 0.450 40.497 0.606 6.127 -0.247 0.170
China Jan-95 0.285 8.450 -0.180 4.143 0.061 0.673 0.639 55.297 0.042 3.581 -0.293 0.826
France Aug-87 -0.030 5.800 -0.543 4.452 0.078 0.000 1.150 50.336 0.111 5.997 -0.409 0.000
Germany Jan-93 0.213 5.772 -0.655 5.162 0.065 0.072 0.970 49.117 0.987 9.186 -0.356 0.100
India Jan-03 0.709 6.844 -0.521 5.235 0.114 0.160 0.537 40.634 -0.270 6.935 -0.331 0.106
Ireland Jan-85 0.161 6.083 -1.076 6.464 0.207 0.018 0.424 53.067 0.200 3.129 -0.497 0.000
Italy Jan-98 -0.362 6.449 -0.229 3.616 0.066 0.151 0.560 34.914 0.059 4.908 -0.395 0.194
Japan Jun-88 -0.273 6.223 -0.533 4.049 0.058 0.000 0.240 31.185 -0.127 3.564 -0.323 0.000
Korea South Jan-90 -0.379 7.997 0.132 5.481 0.107 0.192 0.479 40.296 0.413 5.724 -0.245 0.075
Netherlands Mar-03 0.208 5.007 -1.318 6.705 0.160 0.002 0.018 34.886 -0.051 4.316 -0.422 0.000
Russia Oct-95 -0.368 14.193 -1.373 9.146 0.220 0.280 0.197 66.080 -0.182 4.583 -0.380 0.001
Spain Jan-01 -0.197 5.769 -0.458 3.626 0.092 0.096 1.077 49.252 -0.175 5.947 -0.193 0.141
United Kingdom Jan-97 -0.039 4.114 -0.796 4.018 0.045 0.003 3.178 49.204 1.889 16.273 -0.283 0.001
United States Jan-85 0.379 4.402 -1.061 6.629 0.058 0.008 0.345 31.010 0.875 9.117 -0.175 0.014
Global Jan-97 0.791 22.389 1.164 8.381 -0.077 0.345

40
 Table III: Unconditional correlations
This table reports the unconditional correlations between country index excess returns and one period lagged
economic policy uncertainty shock. ***, **, and * denote the correlation is statistical significance at the 1%, 5%,
and 10% levels, respectively.

Country Country EPU Global EPU

Correlation t-statistic Correlation t-statistic
Australia -0.228*** -2.915 -0.179** -2.261
Brazil 0.030 0.375 -0.157** -1.973
Canada -0.232*** -2.968 -0.240*** -3.074
China -0.110 -1.380 -0.098 -1.222
France -0.046 -0.573 -0.126 -1.576
Germany -0.031 -0.389 -0.156** -1.968
India -0.015 -0.184 -0.222*** -2.829
Ireland -0.054 -0.678 -0.155* -1.959
Italy -0.172** -2.171 -0.100 -1.251
Japan -0.277*** -3.593 -0.243*** -3.121
Korea South -0.191** -2.424 -0.196*** -2.485
Netherlands -0.013 -0.156 -0.134* -1.687
Russia -0.019 -0.239 -0.240*** -3.084
Spain -0.049 -0.608 -0.076 -0.946
United Kingdom 0.035 0.437 -0.174** -2.202
United States -0.263*** -3.399 -0.245*** -3.147

41
 Table IV: Endogeneity test
This table reports the results for endogeneity test in the predictive regression model. The endogeneity test is based
on a regression of residuals from the predictive regression model on residuals from the first-order autoregressive
predictor regression model. The equation is as below:

where is the residual from the predictive regression model and is the residual from
the AR(1) regression of the predictor . We report the p-value of the test that
coefficient in the equation is zero. Rejecting the null that suggests the endogeneity exists in the predictive
regression model. ***, **, and * denote the statistical significance at the 1%, 5%, and 10% levels, respectively.
Country EPU Global EPU
Australia -0.028*** 0.000 -0.050*** 0.000
Brazil -0.026* 0.069 -0.101*** 0.000
Canada -0.028*** 0.000 -0.070*** 0.000
China -0.023** 0.022 -0.068*** 0.004
France -0.025*** 0.000 -0.099*** 0.000
Germany -0.033*** 0.000 -0.115*** 0.000
India -0.063*** 0.000 -0.048** 0.036
Ireland -0.002 0.757 -0.109*** 0.000
Italy -0.055*** 0.000 -0.109*** 0.000
Japan -0.019* 0.095 -0.106*** 0.000
Korea South -0.048*** 0.000 -0.098*** 0.000
Netherlands -0.062*** 0.000 -0.083*** 0.000
Russia -0.038*** 0.008 -0.170*** 0.000
Spain -0.035*** 0.000 -0.093*** 0.000
United Kingdom -0.020*** 0.000 -0.071*** 0.000
United States -0.043*** 0.000 -0.068*** 0.000

42
 Table V: In-sample predictability of excess returns
This table reports results on excess return predictability using domestic and global economic policy uncertainty
shock. The predictive regression model is bias-adjusted FGLS estimator proposed by Westerlund and Narayan
(2015).The coefficient of the predictors is reported. *, **, and *** denote significance at the 10%, 5% and 1%
levels, respectively.
Country EPU Global EPU
Coefficient t-statistic Coefficient t-statistic
Australia -0.016*** -2.617 -0.013 -1.062
Brazil 0.002 0.188 -0.007 -0.271
Canada -0.012** -2.029 -0.035** -2.518
China -0.015 -1.525 -0.024 -1.020
France 0.005 0.513 -0.021 -1.229
Germany -0.001 -0.091 -0.021 -1.107
India 0.001 0.082 -0.060*** -2.734
Ireland -0.005 -0.962 -0.025 -1.409
Italy -0.031** -2.411 -0.015 -0.820
Japan -0.027** -2.547 -0.052*** -2.873
Korea South -0.020** -2.114 -0.037* -1.787
Netherlands 0.008 0.703 0.000 0.019
Russia 0.003 0.238 -0.063 -1.621
Spain 0.005 0.551 -0.010 -0.597
United Kingdom 0.004 0.664 -0.017 -1.311
United States -0.017** -2.197 -0.031** -2.255

43
 Table VI: Out-of-sample evaluations of forecasting of excess returns
This table reports out-of-sample evaluations of the importance of economic policy uncertainty in forecasting excess
returns vis-à-vis a constant returns model. A 50% in-sample period is used to generate recursive forecasts of excess
returns for the remaining 50% of the sample. We report the out-of-sample ( ), which examines the difference in
the mean squared errors from the competition model and the constant returns model. The Clark and West MSFE-
adjusted test statistic, denoted with an asterisk, examines the null hypothesis that the against the
alternative that ; *,**, and *** denote rejection of the null hypothesis at the 10%, 5%, and 1% levels of
significance, respectively.
Country EPU Global EPU
(%) p-value (%) p-value
Australia 1.579* 0.095 0.337 0.341
Brazil -1.712 0.675 -4.013 0.702
Canada 2.696*** 0.007 3.038** 0.041
China 0.409 0.223 0.143 0.282
France -0.713 0.575 0.011 0.199
Germany 1.926** 0.022 1.165 0.146
India 0.293** 0.033 -12.384 0.109
Ireland 1.556** 0.025 2.374** 0.013
Italy 1.002 0.116 2.203* 0.070
Japan 5.687*** 0.001 3.192** 0.018
Korea South 8.162*** 0.001 1.719** 0.033
Netherlands -0.313 0.233 10.995** 0.020
Russia -0.561 0.548 2.738** 0.037
Spain 0.226 0.350 5.155*** 0.005
United Kingdom 2.919** 0.035 0.489 0.258
United States 2.331** 0.014 2.458** 0.034

44
 Table VII: Sources of predictability from cash flow and/or discount rate channels
This table report results based on the following model:

Where dependent variable Y is DP and DG. is the index’s log dividend-price ratio (used as a proxy for discount
rate) and represents the index’s log dividend growth rate (used as a proxy for cash flow). We report for each
predictive regression using ordinary least squares and standard errors are corrected using the Newey–West (1987)
standard errors that are robust to heteroskedasticity and autocorrelation of up to 12 lags. The coefficients are
multiplied by 1000 in the cases of dependent variable is DP. ***, **, and * denote the statistical significance at the
1%, 5%, and 10% levels, respectively. The results are for the countries that have statistically significant in-sample
and/or out-of-sample predictability only.
Panel A: Countries
Country EPU Global EPU
DP DG DP DG
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
Australia 0.110** 2.184 -0.011 -1.414 --- --- --- ---
Canada 0.002 0.051 -0.003 -0.059 0.005 0.069 -0.046 -0.329
India 0.123** 2.104 0.003 0.656 0.403*** 4.882 -0.033** -2.316
Ireland 0.406*** 2.572 -0.035 -0.786 3.192* 1.745 -0.055 -0.020
Japan 0.091** 2.086 0.063* 1.915 0.176 0.989 0.132** 2.081
Korea South 0.159 1.227 0.010 0.629 0.416*** 3.121 -0.226 -1.531
Netherlands --- --- --- --- 0.659*** 3.013 -0.107 -1.417
Russia --- --- --- --- 0.345 1.085 0.124*** 3.599
Spain --- --- --- --- 0.119 0.807 -0.093 -1.286
United Kingdom 0.018 1.188 0.012 0.640 --- --- --- ---
United States 0.051 0.684 -0.052 -1.541 0.341** 2.264 -0.035* -1.705

45
 Table VIII: Mean-variance investor utility gains
This table reports utility gains for a mean–variance investor based on a competition forecasting model vis-à-vis a
constant returns model. A 50% in-sample period is used to generate recursive forecasts of excess returns for the
remaining 50% of the sample. Utilities are computed based on first estimating the portfolio weight, which is an
increasing function of return forecasts and a decreasing function of the return variance and the risk aversion factor.
The risk aversion factor equals six and the variance is computed using a recursive window of historical monthly
stock returns. The portfolio weight is restricted to be between 0 and 1, implying that there is no short-selling
and no borrowing while the portfolio weight is restricted to be between -0.5 and 1.5, , which allows for
short-selling and borrowing. Our portfolio is a two-asset portfolio, where one is a risky asset and the other is a risk-
free asset. The portfolio weight is used to decide the proportion of a dollar to be invested in the risky asset (which is
the stock market) and the risk-free asset (which is the three-month bill rate). As is common in this mean–variance
setup, we make two assumptions: (a) investors only use public information to forecast the one-period ahead excess
returns; and (b) investors rebalance their portfolio once a year. The utility gains are the difference between the utility
from trading strategy based on completion model and constant returns model. The utility gains are annualized and
reported. The results are for the countries that have statistically significant in-sample and/or out-of-sample
predictability only.
Country EPU Global EPU

Australia -0.176 1.489 --- ---

Canada 1.417 2.468 0.731 1.279
Germany 0.293 -0.360 --- ---
India 0.953 0.361 -0.070 0.915
Ireland 1.257 1.660 2.089 2.634
Italy 0.041 0.866 -0.884 1.604
Japan 3.434 5.026 1.698 3.715
Korea South 1.448 3.400 0.426 2.423
Netherlands --- --- 1.557 3.245
Russia --- --- 0.286 2.252
Spain --- --- 0.506 4.699
United Kingdom 0.703 2.040 --- ---
United States 2.719 2.939 3.022 3.748

46
 Table IX: Sector level results
This table reports the results for in-sample predictability, out-of-sample forecasting, and mean–variance utility gains
at sector level. The utility gains results are for the sectors that have statistically significant in-sample and/or out-of-
sample predictability only. *,**, and *** denote rejection of the null hypothesis at the 10%, 5%, and 1% levels of
significance, respectively.
Panel A: In-sample test
Country EPU Global EPU
Coefficient t-stat Coefficient t-stat
Basic Materials -0.007 -0.669 -0.021 -1.043
Consumer Goods -0.019** -2.145 -0.027* -1.721
Consumer Services -0.023*** -2.582 -0.038** -2.488
Financials -0.026*** -2.814 -0.049*** -2.996
Healthcare -0.012* -1.648 -0.015 -1.196
Industrials -0.021** -2.285 -0.035** -2.091
Oil & Gas -0.033*** -3.654 -0.042** -2.319
Technology -0.012 -0.936 -0.037 -1.607
Telecommunications -0.016* -1.876 -0.027 -1.580
Utilities -0.004 -0.553 -0.011 -0.759
Panel B: Out-of-sample test
Country EPU Global EPU
(%) p-value (%) p-value
Basic Materials -2.040 0.706 -0.177 0.301
Consumer Goods -0.760 0.154 3.392** 0.012
Consumer Services 3.339** 0.024 -0.707 0.467
Financials 3.707*** 0.008 6.089*** 0.003
Healthcare -5.495 0.499 -4.148 0.430
Industrials 1.302** 0.031 1.281* 0.051
Oil & Gas 0.487* 0.087 1.306* 0.080
Technology 1.999* 0.062 0.942* 0.091
Telecommunications 4.169*** 0.007 1.975* 0.063
Utilities 0.217 0.213 -1.884 0.488
Panel C: Utility gains
Country EPU Global EPU

Consumer Goods 1.249 0.839 1.902 2.285

Consumer Services 0.746 1.834 3.264 2.422
Financials 3.015 3.678 4.174 6.245
Healthcare -0.892 -3.328 --- ---
Industrials 2.238 1.745 3.777 3.370
Oil & Gas 1.662 0.963 0.512 0.664
Technology 2.142 2.387 1.537 2.555
Telecommunications 2.109 3.982 2.511 2.885

47
 Table X: Stock returns predictability using positive and negative EPU shocks
This table reports results on excess return predictability using positive and negative economic policy uncertainty
shocks. Positive shocks, , which indicates EPU increase, and negative shocks
, which indicates EPU decrease. The predictive regression model is bias-adjusted FGLS estimator
proposed by Westerlund and Narayan (2015).The coefficient of the predictors is reported. *, **, and *** denote
significance at the 10%, 5% and 1% levels, respectively.
Panel A: Countries
Country EPU Global EPU
Positive shocks Negative shocks Positive shocks Negative shocks
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
Australia -0.013 -1.397 -0.029*** -2.977 -0.024 -1.372 -0.017 -0.825
Brazil -0.013 -0.705 0.018 0.981 -0.047 -1.151 -0.017 -0.334
Canada -0.011 -1.292 -0.021** -2.172 -0.049*** -3.104 -0.026 -1.212
China -0.022 -1.363 -0.016 -0.995 -0.077** -2.340 0.053 1.174
France 0.007 0.746 -0.007 -0.741 -0.050* -1.946 -0.008 -0.273
Germany 0.002 0.146 -0.004 -0.290 -0.021 -0.722 -0.039 -1.133
India -0.015 -0.806 0.001 0.035 -0.120*** -4.076 -0.061 -1.562
Ireland 0.000 -0.008 -0.017* -1.737 -0.033 -1.206 -0.031 -1.037
Italy -0.041* -1.914 -0.039* -1.930 -0.048* -1.658 -0.005 -0.142
Japan -0.043** -2.281 -0.034** -1.969 -0.062** -2.275 -0.079** -2.430
Korea South -0.033** -2.111 -0.028* -1.657 -0.042 -1.327 -0.065 -1.718
Netherlands 0.016 0.873 0.002 0.111 -0.065** -2.307 -0.092** -2.151
Russia 0.008 0.376 0.003 0.160 -0.081 -1.411 -0.074 -1.039
Spain 0.009 0.608 0.002 0.162 -0.009 -0.303 0.010 0.288
United Kingdom 0.015 1.480 -0.003 -0.317 -0.021 -1.073 -0.015 -0.663
United States -0.024** -2.130 -0.027** -2.052 -0.041** -2.039 -0.037 -1.524
Panel B: Sectors
Country EPU Global EPU
Positive shocks Negative shocks Positive shocks Negative shocks
Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
Basic Materials -0.008 -0.465 -0.019 -1.026 -0.025 -0.831 -0.029 -0.810
Consumer Goods -0.018 -1.342 -0.039** -2.440 -0.032 -1.354 -0.042 -1.477
Consumer Services -0.026** -1.961 -0.035** -2.277 -0.049** -2.121 -0.042 -1.512
Financials -0.036*** -2.690 -0.033** -1.999 -0.076*** -3.263 -0.042 -1.385
Healthcare -0.015 -1.322 -0.020 -1.547 -0.013 -0.668 -0.027 -1.197
Industrials -0.027* -1.955 -0.034** -2.116 -0.047* -1.877 -0.043 -1.445
Oil & Gas -0.044*** -3.238 -0.036** -2.244 -0.063** -2.345 -0.045 -1.363
Technology -0.017 -0.922 -0.019 -0.883 -0.046 -1.410 -0.046 -1.166
Telecommunications -0.024* -1.717 -0.021 -1.398 -0.038 -1.464 -0.040 -1.257
Utilities -0.005 -0.418 -0.008 -0.662 -0.013 -0.608 -0.016 -0.641

48
 Table XI: Out-of-sample forecasting results using 30% and 70% in-sample periods
This table reports out-of-sample evaluations of the importance of economic policy uncertainty in forecasting excess
returns vis-à-vis a constant returns model. A 30% (70%) in-sample period is used to generate recursive forecasts of
excess returns for the remaining 70% (30%) of the sample. We report the out-of-sample ( ), which examines
the difference in the mean squared errors from the competition model and the constant returns model. The Clark and
West MSFE-adjusted test statistic, denoted with an asterisk, examines the null hypothesis that the against
the alternative that ; *,**, and *** denote rejection of the null hypothesis at the 10%, 5%, and 1% levels
of significance, respectively.
Panel A: 30% in-sample period
Country EPU Global EPU
(%) p-value (%) p-value
Australia 0.689 0.137 -0.690 0.479
Brazil -2.661 0.811 -3.520 0.721
Canada 2.917*** 0.002 3.534** 0.023
China 1.823** 0.065 0.365 0.231
France 0.135 0.223 -0.472 0.251
Germany 1.437** 0.013 0.454 0.202
India 4.178** 0.011 -4.340 0.102
Ireland -0.367 0.181 0.637* 0.082
Italy 0.494* 0.084 2.249* 0.058
Japan 2.368*** 0.005 5.613*** 0.001
Korea South 3.908** 0.018 4.542*** 0.003
Netherlands 4.414** 0.013 5.618*** 0.008
Russia 1.759* 0.052 4.178*** 0.007
Spain 0.408 0.171 1.544* 0.075
United Kingdom 4.690** 0.036 3.500* 0.097
United States -1.680 0.118 1.348** 0.048
Panel B: 70% in-sample period
Country EPU Global EPU
(%) p-value (%) p-value
Australia -2.960 0.409 0.983 0.216
Brazil -1.558 0.766 -1.044 0.400
Canada 3.752** 0.013 -5.318 0.146
China 3.926** 0.047 2.060 0.128
France -0.665 0.638 -2.608 0.405
Germany 0.760 0.158 0.859 0.250
India -7.259 0.160 -27.092 0.407
Ireland 3.153*** 0.001 1.682 0.111
Italy 1.456 0.149 5.032** 0.025
Japan 6.193*** 0.003 4.119** 0.031
Korea South 1.933 0.128 -0.387 0.116
Netherlands -0.901 0.320 3.510* 0.098
Russia -0.853 0.588 -2.871 0.234
Spain 1.277 0.254 1.603 0.179
United Kingdom 3.402** 0.021 2.324 0.120
United States 1.672* 0.065 -6.494 0.348

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 Table XII: Mean-variance investor utility gains using risk aversion 3
This table reports utility gains for a mean–variance investor based on a competition forecasting model vis-à-vis a
constant returns model. A 50% in-sample period is used to generate recursive forecasts of excess returns for the
remaining 50% of the sample. Utilities are computed based on first estimating the portfolio weight, which is an
increasing function of return forecasts and a decreasing function of the return variance and the risk aversion factor.
The risk aversion factor equals three and the variance is computed using a recursive window of historical monthly
stock returns. The portfolio weight is restricted to be between 0 and 1, implying that there is no short-selling
and no borrowing while the portfolio weight is restricted to be between -0.5 and 1.5, , which allows for
short-selling and borrowing. Our portfolio is a two-asset portfolio, where one is a risky asset and the other is a risk-
free asset. The portfolio weight is used to decide the proportion of a dollar to be invested in the risky asset (which is
the stock market) and the risk-free asset (which is the three-month bill rate). As is common in this mean–variance
setup, we make two assumptions: (a) investors only use public information to forecast the one-period ahead excess
returns; and (b) investors rebalance their portfolio once a year. The utility gains are the difference between the utility
from trading strategy based on completion model and constant returns model. The utility gains are annualized and
reported. The results are for the countries that have statistically significant in-sample and/or out-of-sample
predictability only.
Country EPU Global EPU

Australia 1.532 3.297 --- ---

Canada 2.209 4.039 2.235 3.845
Germany 0.588 -0.600 --- ---
India 1.918 1.078 1.559 2.915
Ireland 2.521 3.348 5.008 5.979
Italy 1.108 2.459 -0.548 2.249
Japan 5.395 9.910 1.548 4.715
Korea South 2.594 6.266 0.982 4.738
Netherlands --- --- 3.237 5.212
Russia --- --- 0.386 3.400
Spain --- --- 1.117 6.859
United Kingdom 1.643 3.157 --- ---
United States 4.590 6.142 5.631 7.772

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 Can Economic Policy Uncertainty Predict Stock Returns? Global Evidence

HIGHLIGHTS

 We test whether economic policy uncertainty (EPUI) predict excess stock returns.

 We find in-sample predictability is country/sector dependent.

 We find out-of-sample predictability is country/sector dependent.

 We find predictability of stock returns are through discount rate channel.

 We find evidence of asymmetric predictability.

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