Economic policy uncertainty, market returns and expected return predictability

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Abstract
Purpose: Using the economic policy uncertainty (EPU) index as a proxy for the level of EPU, we study the impact of the level of EPU on the conditional mean of market returns and we examine the predictive power of EPU on future market returns. Design/methodology/approach: We employ a GARCH-in-Mean model with exogenous variables. Findings: The results show that even after controlling for business cycle effects, EPU is inversely related to contemporaneous market returns. Particularly, the authors find that the negative impact of EPU subsists only during recessions or recessionary states of the economy, and has no discernible effects during expansionary periods. Originality/value: This is the first study to examine the predictive power of EPU on future market returns.

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