Frequency-domain approach to the causal nexus between domestic and international economic policy uncertainties and equity returns of G20 countries

Abstract

While uncertainty shocks affect equity markets at various investment horizons, knowledge about the causal effects of uncertainty and equity markets in the frequency domain is scant among the Group of Twenty (G20) countries regarded as systemically important economies. This paper explores the causal relations between domestic and international (US) economic policy uncertainties (EPU) and equity market returns of G20 countries. By employing the frequency-domain causality test, with monthly data spanning January 1997 to June 2021, we reach the following conclusions: 1) irrespective of the frequency, there is more support for the equity-leading hypothesis, implying that domestic stock market volatility contributes to increasing domestic policy uncertainty, as policymakers occasionally have to alter policies in reaction to elevated stock market volatility; 2) the causality between policy uncertainty (whether domestic or international) and equity returns is sensitive to heterogeneous investment decisions and policy uncertainty across horizons in most of our sample; 3) International (US) policy uncertainty has a domineering causal effect in predicting domestic equity returns, relative to domestic policy uncertainty in the short run of about 2.5 months or less. Therefore, the prediction that stock prices fall following government policy announcements is not always supported since countries are different.

Keywords

• Economic policy uncertainty
• frequency-domain causality approach
• G20 equity markets
• equity-leading hypothesis
• uncertainty-leading hypothesis
• fractal market hypothesis