Effects of Economic Policy Uncertainty Shocks on the Long-Run US-UK Stock Market Correlation

Abstract

We study the impact of economic policy uncertainty (EPU) shocks on the long-run stock market variances and correlations, primarily for the US and the UK. We find that US EPU shocks affect both US and UK stock market long-run variances and correlation, but UK EPU shocks only affect its own long-run variance. The results are consistent when we include more countries in an international analysis. We demonstrate the practical importance of including EPU shocks in international portfolio analysis. A comparative analysis shows that EPU shocks convey important information about the long-run variances and correlation, even after accounting for a number of alternative uncertainty measures, and that it performs better out-of-sample than most of the alternative uncertainty measures.

Keywords: economic policy uncertainty index; mixed data sampling; stock market correlation; stock market volatility

JEL Classification: G11, G15, G30, C32