Testing output gap and economic uncertainty as an explicator of stock market returns

This study examines whether output gap along with the US economic uncertainty can explain the variations in stock market returns of G7 and IBSA (India, Brazil and South Africa) countries. Using quarterly data on output gap and US economic policy uncertainty index, the study reports following empirical regularities. First, there is a significant impact of immediate lag of output gap on stock market return, implying that output gap can help predict the stock market returns. Second, US economic policy uncertainty impacts these markets negatively. Third, the results of the country-specific output gap and global (common) output gap indicate that the impact of the global output gap is relatively stronger compared to country specific output gap on stock market returns of most of the G7 and IBSA countries. Fourth, these results are further confirmed by directional interdependence approach except Brazil and India where the stock market appears as an explicator of economic activity. Fifth, under the time-varying framework, the results show that for emerging markets, global output gap along with economic policy uncertainty explains variations in stock market returns. Overall, our findings thus suggest that output gap along with economic uncertainty can be considered as an important explicator of stock market returns in case of developed and emerging markets.