Fear Propagation and Return Dynamics

In this paper, we show that fear can propagate across international financial markets. Investors become more concerned about the local market tail risks when they see that the U.S. economy steps into contractions. Consistent with the rare disaster theory, risk-averse investors would require higher risk premiums, corresponding to lower stock market prices. By considering precious metals, in particular the log gold-to-platinum ratio justified by Huang and Kilic (2019), as the global market fear proxy, we show that the fear propagation shapes the return dynamics at the international level. By applying the state-switching model recently proposed by Jacobsen, Marshall, and Visaltanachoti (2019), we find the return predictability stems from the periods when the U.S. economy is in contractions but not in expansions. The evidence is robust across different business cycle definitions, and the pattern holds at multiple-horizons from one week to one year. Further evidence shows that the predictive power of this ratio during bad states is not due to the U.S. stock market spillover effect, and not subsumed by macroeconomic fundamentals and financial variables. Overall, the out-of-sample performance suggests the important implications of the proxy for international return predictability during the bad economic states