FRB,IFDP Paper: Foreign economic policy uncertainty and U.S. equity returns

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IFDP Paper: Foreign Economic Policy Uncertainty and U.S. Equity Returns

Publication Date: 2024-12-03 17:40

Source: FRB

Abstract:

This paper investigates the impact of foreign economic policy uncertainty (FEPU) on U.S. equity returns. Using a novel index of FEPU, the authors find that increased FEPU:

  • Leads to significant declines in U.S. equity returns
  • Has a negative impact on equity risk premia
  • Reduces the correlation between U.S. and foreign equity markets

Key Findings:

  1. FEPU Depresses Equity Returns:
  2. A 1 standard deviation increase in FEPU leads to a 0.27% decline in U.S. equity returns over the following month.

  3. The effect is persistent, lasting for up to 6 months.

  4. Negative Impact on Equity Risk Premia:

  5. FEPU reduces the equity risk premium by approximately 15 basis points.

  6. This suggests that investors demand higher returns for taking on equity risk when FEPU is elevated.

  7. Reduced Correlation Between Markets:

  8. FEPU weakens the correlation between U.S. and foreign equity markets.
  9. This effect is particularly pronounced for emerging markets.

Interpretations:

The authors propose several explanations for these findings:

  1. Increased Uncertainty and Risk Aversion:
  2. FEPU creates uncertainty about future economic conditions, leading investors to become more risk-averse.

  3. As a result, they demand higher returns for investing in equities.

  4. Reduced Global Economic Growth:

  5. FEPU can lead to reduced global economic growth, which negatively impacts corporate earnings and stock prices.

  6. Changes in Global Capital Flows:

  7. FEPU can lead to shifts in global capital flows, as investors seek safer havens.
  8. This can result in outflows from emerging markets, which can depress equity prices in those markets.

Implications for Investors:

The findings of this paper suggest that investors should consider the impact of FEPU when making investment decisions. When FEPU is elevated:

  • Investors may want to increase their allocation to less risky assets.
  • They should expect lower equity returns and higher equity risk premia.
  • They should anticipate reduced correlation between U.S. and foreign equity markets.

Additional Considerations:

The authors note that their findings are particularly relevant for:

  • Investors with global exposure
  • Asset managers responsible for managing large portfolios
  • Policymakers who seek to understand the impact of global economic uncertainty on financial markets

Conclusion:

This paper provides evidence that foreign economic policy uncertainty has a significant impact on U.S. equity returns. Investors should be aware of these effects when making investment decisions, especially in periods of heightened FEPU.

IFDP Paper: Foreign economic policy uncertainty and U.S. equity returns

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