On Economic Uncertainty, Stock Market Predictability and Nonlinear Spillover Effects

This paper uses a k-th order nonparametric Granger causality test to analyze whether firm-level, economic policy and macroeconomic uncertainty indicators predict movements in real stock returns and their volatility. Linear Granger causality tests show that whilst economic policy and macroeconomic uncertainty indices can predict stock returns, firm-level uncertainty measures possess no predictability. However, given the existence of structural breaks and inherent nonlinearities in the series, we employ a nonparametric causality methodology. We find that aside from economic policy, firm-level uncertainty indicators cause stock returns as well as market volatility. Thus, our results not only emphasize the role of economic and firm-level uncertainty measures in predicting stock returns and volatility, but also presage against using linear models which are likely to suffer from misspecification in the presence of parameter instability and nonlinear spillover effects.