Uncertainty about Government Policy and Stock Prices

TLDR: This paper analyzed how changes in government policy affect stock prices and found that stock prices should fall at the announcements of policy changes, on average, if uncertainty about government policy is large, and also if the policy change is preceded by a short or shallow economic downturn.

Abstract: We analyze how changes in government policy affect stock prices. Our general equilibrium model features uncertainty about government policy and a government whose decisions have both economic and non-economic motives. The model makes numerous empirical predictions. Stock prices should fall at the announcements of policy changes, on average. The price fall should be large if uncertainty about government policy is large, and also if the policy change is preceded by a short or shallow economic downturn. Policy changes should increase volatilities and correlations among stocks. The jump risk premium associated with policy decisions should be positive, on average.

Figures

Figure 15. Different government policy exposures. This figure plots the results from the extension of the benchmark model in which there are two types of firms with different exposures to government policy, βH and βL. Panel A plots the stock return expected at the announcement of a policy change, or EAR, when half of the firms as of time 0 have βH = 1.5 and the other half have βL = 0.5. Panel B plots EAR as a function of βH − βL while varying w0, the fraction of high-beta firms as of time 0. Panels C and D plot the difference in the conditional expected returns of the high-beta and low-beta firms, µH − µL, as a function of βH − βL while varying wt, the fraction of high-beta firms as of time t = 5 years. In Panel C, ĝt = 2%, whereas in Panel D, ĝt = −2%. In Panels B, C, and D, we vary β H − βL while holding the average of the two betas constant, (βH + βL)/2 = 1. Unless specified otherwise, the parameters are from Table 1.

Figure 1. Profitability dynamics and the policy decision. This figure plots the expected dynamics of ĝt (solid line) and realized profitability (dashed line) under the parameter values from Table 1. Realized profitability is the average profitability across all firms, plotted in excess of µ so that its unconditional mean is zero. The figure also plots the threshold g(c) (dotted line). All three lines are average paths across many simulated samples. The top panel averages across the samples in which a policy change occurred at time τ = 10, whereas the bottom panel conditions on no policy change.

Figure 11. Properties of returns around policy decisions that result in no policy change. This figure plots the expected dynamics of the volatility of the stochastic discount factor, σπ,t (Panel A), the conditional expected stock market return, µM,t (Panel B), the conditional volatility of stock market returns, σM,t (Panel C), and the pairwise correlation between stocks, ρt (Panel D), all conditional on no policy change at time τ = 10. The jump-related components at time τ are not plotted. The downturn length is τ − t0 = 5 years, so that ĝ5 = 0. The parameters are in Table 1, except for σg, which takes three different values, 1%, 2%, and 3% per year.

Figure 5. Announcement return and the downturn length and depth. Panel A plots the announcement return R(ĝτ), the instantaneous stock return at the announcement of a policy change at time τ , as a function of the length and depth of the downturn that precedes the policy change. The downturn length is computed as τ − t0 > 0, where ĝt0 = 0. The downturn depth is given by the number of standard deviations by which ĝt drops during the downturn. Panel B plots the corresponding probability of a policy change, as perceived by investors just before time τ . The parameters are from Table 1.

Figure 12. The level and volatility of stock prices around policy changes. This figure plots the dynamics of the level and volatility of stock prices around policy changes at time τ = 10 in two scenarios: (i) when policy changes are allowed (our model—solid line), and (ii) when policy changes are precluded (hypothetical scenario—dashed line). Panels A and B plot the expected dynamics of the stock market value Mt, whereas Panels C and D plot the expected dynamics of stock market volatility σM,t. Market value is in units of book value at time 0; volatility is in percent per year. The downturn length is τ − t0 = 1 year in Panels A and C, but 5 years in Panels B and D. The parameters are in Table 1.

Table 1 Parameter Choices