Economic Policy Uncertainty in China and Stock Market Expected Returns

Abstract

We investigate the impact of China’s economic policy uncertainty (EPU) on the time series variation of Chinese stock market expected returns. Using the news based measure in Baker, Bloom, and Davis (2016), we find that EPU predicts negatively future stock market return at various horizons. This negative relation between economic policy uncertainty and expected future return remains significant as we control for a number of economic and market uncertainty variables or conduct out-of-sample tests. Our findings are consistent with asset pricing theories with belief dispersion, in which high uncertainty or investors disagreement generates speculative mispricing when pessimistic investors face short-sales constraints.

Keywords: Return Predictability, Economic Policy Uncertainty, Out-of-sample Forecasting, Asset Allocation, Chinese Stock Market

JEL Classification: C22, C53, G11, G12, G17