Central Banks Notes

Exploring the Impact of Foreign Economic Policy on US Equity Markets

Mohammad R. Jahan-Parvar's MathWorks Finance Conference presentation, "Foreign Economic Policy Uncertainty and US Equity Returns," investigates the connection between global economic uncertainties and US equity markets.

Key takeaways include:

• Methodology and Analysis: The presentation orthogonalizes global EPU with respect to US EPU to isolate the effects of foreign economic policies. This approach allows a clearer understanding of how international uncertainties influence US equity returns.
• Predictive Power of Foreign EPU: Jahan-Parvar's analysis reveals that foreign EPU has a significant predictive capability for aggregate US stock returns, particularly when forecasting 6 to 12 months out. This finding is crucial for investors and policy makers to consider in their strategic planning.
• Impact on Portfolio Returns: The presentation delved into the effects of foreign EPU on various portfolio returns, including those based on size, investment, capital expenditure, and foreign sales. This comprehensive approach highlights the widespread impact of foreign EPU across different sectors.
• Cross-Sectional Analysis: In the cross-section of returns, foreign EPU commands a notable and negative value premium. Stocks of firms that are highly sensitive to foreign EPU tend to outperform less sensitive stocks, regardless of the direction of this sensitivity.
• Firm Characteristics and Sensitivity: Jahan-Parvar identified specific firm characteristics that correlate with sensitivity to foreign EPU. These include larger firms, and firms with a low book-to-market ratio, high investment and operating profitability, high idiosyncratic volatility, cash-flow constraints, and significant foreign sales and CapEx outlays.
• Implications for Investors: The findings have profound implications for investors, especially those with global exposure. Understanding the dynamics of foreign EPU can result in better portfolio management and risk assessment strategies.