Recently, there has been rampant political uncertainty, with conflicts in Ukraine and Gaza, the debt ceiling crisis, and divisive presidential elections with Trump and Biden dominating headlines worldwide. While political news has been observed to significantly influence market movements, it is noticeable that traditional finance theory often overlooks its role. This raises questions about how political news impacts stock prices. One key aspect is its effect on unexpected future cash flows, as well as its influence on the cost of capital through changes in discount rates. This prompts consideration of whether political uncertainty carries a risk premium, and if so, how significant it is. During the UK fall seminar, Pietro Veronesi presented his research ‘Political uncertainties and asset prices’ which addresses these issues
For those who were unable to attend his presentation, a summary has been made:
“The typical textbook model depicts businesses as operating in an external economic environment. This picture, however, ignores the important role that governments play in shaping the economic landscape. Governments set regulations for issues like immigration, healthcare, minimum wage and work limitations, among other things.
Moreover, there seems to be a need for a benchmark theoretical model. With political uncertainty on the rise and it becoming more apparent that political news have the ability to move markets, one wonders why there is no role for political news in finance theory. I therefore ask myself, does political uncertainty carry a risk premium?
The data that we used for this study includes data from 20 countries, provided by option metrics that includes put options on each country’s premier stock market index for 15 countries and ETFs based on the country’s MSCI index for the remaining 5 countries. The political events we considered for this study were national elections as well as global summits such as the G8, the G20 and European summits. Economic conditions were assessed based on various factors including Realized real GDP growth and forecasts from the OECD and IMF respectively, Composite leading indicator from the OECD, and stock market index returns from Datastream. Political uncertainty, specifically for elections, is quantified using UNC, calculated as the negative of the poll spread from the most recent opinion polls before elections.
We concluded that economic downturns are often accompanied by a rise in political uncertainty, which raises the risk premium attached to it. This is because political uncertainty amplifies the effect of economic downturns on risk premia. Because of the increased political unpredictability, discount rates rise, which in turn causes a decline in business valuation and thus, potentially, a reduction in employment and investment. Moreover, economic downturns also increase the chance of Democratic presidencies, which has historically been linked to higher average returns and is especially noticeable in the first year of office”.
View the research in full via Joint Spring Seminar 2024, United Kingdom • Inquire Europe (inquire-europe.org)