The impacts of global economic policy uncertainty on stock market returns in regime switching environment: Evidence from sectoral perspectives

• Date: 01 April 2019
• DOI: http://doi.org/10.1002/ijfe.1702
• Author: Mohd Azlan Shah Zaidi,Mohammad Enamul Hoque
• Published date: 01 April 2019

RESEARCH ARTICLE

The impacts of global economic policy uncertainty on stock

market returns in regime switching environment: Evidence

from sectoral perspectives

Mohammad Enamul Hoque

1

| Mohd Azlan Shah Zaidi

2

1

Graduate School of Business, Universiti

Kebangsaan Malaysia (The National

University of Malaysia), Malaysia

2

Faculty of Economics and Management,

Universiti Kebangsaan Malaysia (The

National University of Malaysia), Malaysia

Correspondence

Mohammad Enamul Hoque, Graduate

School of Business, Universiti Kebangsaan

Malaysia (The National University of

Malaysia).

Email: iiuc.enam@ymail.com

JEL Classification: C58; E32; E37; E44;

E52; E62; F5; F65; G10

[Correction added on 14 November 2018,

after first online publication: the full name

of the author “Mohd Alzan Shah Zaidi”

has been corrected to “Mohd Azlan Shah

Zaidi”].

Abstract

This study contributes in building emerging literature by investigating the

impacts of global economic policy uncertainty on Malaysian sectoral stock per-

formance. This study models sectoral stock returns as time‐varying transition

probability Markovian processes and employs two‐stage Markov‐switching

model for findings impacts of global economic policy uncertainty on sectoral

stock returns in regime switching environment. The empirical results reveal

that linear framework unable to detect the effects global economic policy

uncertainty, and the Markov‐switching model exhibits significant effects of

global economic policy uncertainty on all sectoral stock returns excluding tech-

nology sector in Malaysia stock market. The findings also expose that the

effects of global economic policy uncertainty vary across regime states, sectors,

and nature of effects, where the negative effects of global economic policy

uncertainty dominate over positive effects. The global economic policy uncer-

tainty exhibits greater impacts on stock returns in high‐volatility regime. Thus,

the findings confirm the existence of asymmetric, nonlinear, nonmonotonic,

and state‐dependent relationship between global economic policy uncertainty

and sectoral stock returns in Malaysia. Therefore, the overall empirical findings

can be applied in asset pricing and investment decision‐making purposes. The

findings also suggest that global economic policy uncertainty can be a systemic

risk factor and predictor of stock market returns.

Highlights

•Linear framework unable to detect the impacts of global economic policy

uncertainty.

•Nonlinear framework detects the impacts of global economic policy

uncertainty.

•The global economic policy uncertainty has significant effects on all sectoral

stock returns in Malaysia stock market.

•The effects of global economic policy uncertainty vary across regime states,

sectors, and nature of effects.

•Negative effects of global economic policy uncertainty dominate positive

effects.

Received: 18 March 2018 Revised: 5 August 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1702

Int J Fin Econ. 2019;24:991–1016. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 991

•The global economic policy uncertainty has greater impacts on stock returns

in high‐volatility regime.

•The global economic policy uncertainty can be considered as a systemic risk

factor and a predictor of stock market returns.

KEYWORDS

emerging stock market, global economic policy uncertainty,Malaysia, Markov‐switching process,

sectoral stock returns

1|INTRODUCTION

The literature of empirical finance has been proliferating

and flourishing with studies of global risk factors and

stock market returns. It is not surprising as it has been

documented that the global risk factors, such as geopolit-

ical risk, international economic policy uncertainty

(EPU), and oil price, have significant impacts on stock

performance at aggregated stock market level, industry

level, and firm level (Antonakakis, Chatziantoniou, &

Filis, 2013; Antonakakis, Gupta, Kollias, & Papadamou,

2017; Caldaray & Iacoviello, 2016; Demirer, Jategaonkar,

& Khalifa, 2015; Ferson & Harvey, 1994; Kang et al.,

2017a & 2017b; Kang & Ratti, 2013; Moya‐Martínez,

Ferrer‐Lapeña, & Escribano‐Sotos, 2014; Naifar &

Hammoudeh, 2016; Naifar, Mroua, & Bahloul, 2017;

Reboredo & Naifar, 2017; Reboredo & Uddin, 2016). To

date, many empirical studies have investigated the rela-

tionship between global risk factors and stock market

returns in capital asset pricing model (CAPM) framework

and linear framework (Sadorsky & Henriques, 2001;

Mohanty, Nandha, & Bota, 2010; Waszczuk, 2013;

Brogaard & Detzel, 2015; Moya‐Martínez et al., 2014;

Demirer et al., 2015; Naifar et al., 2017). However, in

the recent time, some empirical studies have analysed

the impacts of global factors on economic and financial

performances considering time varying, structural shifts,

and different market conditions (Arouri, Estay, Rault, &

Roubaud, 2016; Basher, Haug, & Sadorsky, 2018;

Bijsterbosch & Guérin, 2013; Kang, Ratti, & Yoon, 2015;

Ko & Lee, 2015; Zhu, Su, You, & Ren, 2017). These

empirical studies have shown that investigations of the

relationship between global risk factor and financial mar-

ket performance require the nonlinear framework, which

captures the financial market volatilities and structural

shifts in stock market behaviour. In supporting that said,

the historical facts also indicate that there are some struc-

ture changes/shifts transpired in the stock price behav-

iour during some exogenous events,

1

which occurred

owing to oil price changes, global financial market vola-

tilities, global financial policies, geopolitical changes,

and political changes. Given that, in the unstable eco-

nomic conditions, stock returns tend to be negative with

high volatilities and variances (see, Arouri et al., 2016;

Chen & Chiang, 2016). In addition, high uncertainty

periods have been accompanying decreases in stock price

in tandem with weak stock performance, which result in

increased risk and new policy changes in economy

(Bijsterbosch & Guerin, 2013). Henceforth, the unstable

economic conditions lead to change consistency in the

relationship between stock market and influential risk

factors, and thus, the nonlinear relationship between

global risk factors and stock returns can be appeared.

Therefore, the effects global factors risk on stock returns

should be examined in regime shift environments, which

can resolve the sign of the risk–return relationship and

degree of influence on stock performance. Such investiga-

tion can also offer an answer of core question in asset

pricing and portfolio management, presenting a compre-

hensive picture on risk factors' influence on stock

performance.

Global economic policy uncertainty (GEPU) risk is

one of the influential global risk factors in global finan-

cial market performance (see, Arouri et al., 2016; Baker,

Bloom, & Davis, 2016). Therefore, the effect of GEPU

on asset prices/stock returns can be diffused through var-

ious channels. First, the EPU affects decision of economic

agents regarding employment, consumptions, saving,

and investment, which influence stock market participa-

tions and performances directly (Arouri et al., 2016;

Gulen & Ion, 2015). Second, the GEPU annihilates the

financing environment and the degree of economic free-

dom that affect stock market performances through a

reduced amount of both local and international investors'

participations. Third, the GEPU influences commodity

market, such as oil prices, that further affects stock

market and economic performances (see, Kang, Gracia,

1

Events are the stock market crash in 1984, Asian economic crisis in

1996/1997, 9/11 attacks in 2001, the Iraq war in 2003, the financial crisis

in 2007/2008, Arab spring uprising of 2010, oil supply shocks in 2014/

2015, and U.S. Presidential election in 2016, and Br‐exist in 2017.

992 HOQUE AND ZAIDI