Politics, policy, and international stock peturns

Abstract

Politics and policy are distinct, though interrelated, factors affecting the economy. Using novel measures of political stability and confidence in economic policy we document predictable variation in stock market returns and economic growth across countries. Higher political stability and confidence in economic policy lead to higher economic growth and higher stock market returns in developed markets. In emerging markets, they lead to higher economic growth but lower stock market returns. International business cycles, country characteristics, and standard international risk factors do not account for the return patterns across countries. Investment strategies that exploit the politics-policy predictability generate annualized abnormal returns as large as 8.8% for developed markets, and 25.5% for emerging markets. Our results suggest that international financial markets underreact to the predictable economic effects of political stability and economic policy.