Economic Uncertainty and Cross-sectional Asset Pricing

One of the most important challenges in asset pricing is to explain cross-sectional variation in returns across different assets. As returns represent compensation for bearing risk, assets with different risk exposures should earn dissimilar returns. Consequently, investors and researchers have long attempted to specify factors capturing the risk that can drive stock returns by investigating the relationship between the potential risk factors and the future returns. Factors that are closely related to future returns are widely accepted candidates for better explaining return spreads. However, there is no consensus on the predictive power of these potentially competing factors. The intertemporal capital asset pricing model (ICAPM), for example, assumes that investors tend to hedge against unfavorable risk by adjusting their consumption and investment using shifts in future economic conditions and investment opportunities over the long run (Merton, 1973). As such hedging needs affect investor behavior, macroeconomic variables that predict future macroeconomic fundamentals and investment conditions are widely accepted return predictors. Among these macroeconomic factors is economic uncertainty, which measures the turbulence of general economic conditions. This is important as it heightens risks, adversely affects investment, and even triggers global financial crises and worldwide economic downturns. Many studies find that economic uncertainty, being an unfavorable shift in the economic and financial environment, undermines macroeconomic outcomes and eventually drags down market returns at the aggregate level. In their focus on individual stock returns, Bali et al. (2017, 2019a) conclude that domestic uncertainty exposure indeed predicts cross-sectional returns in the US. Motivated by the significant role of uncertainty in affecting macroeconomic conditions and stock market returns, this thesis investigates the relationship between exposure to economic uncertainty and future individual stock returns over multiple trading horizons in non-US markets. It extends the US-based findings of Bali et al. (2017, 2019a) by examining the predictive role of domestic uncertainty exposure for individual stock returns in Australia. In addition to domestic uncertainty, the research considers the spillover effects of uncertainty risk from other markets. Two underlying trends in global economic development serve as background for this analysis. The first is the ongoing integration of the global economy and the comovements existing among financial markets. Motivated by the ongoing integration of the global economy, this thesis then investigates the relationship between risk exposure to global uncertainty and future individual stock returns in the top-five non-US developed markets, comprising the Japanese, UK, Hong Kong, Euronext, and Canadian stock markets. A second trend is the continuing integration of economies in geographically close areas. Motivated by the growing economic power of China in the Asian regional economy, the thesis also investigates the relationship between exposure to Chinese uncertainty and future individual stock returns in the five leading Asian markets, namely, Japan, Hong Kong, India, South Korea, and Taiwan. [...]

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