The role of economic uncertainty in UK stock returns

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