Economic policy uncertainty and stock return synchronicity in the increasingly integrated European Union

Abstract

I analyze how government policy uncertainty and economic integration affect stock return synchronicity in the European Union over the period 1990 to 2015, using the novel economic policy uncertainty indices of Baker, Bloom, and Davis (2015). I find that stock return synchronicity between and inside the member states increases with economic policy uncertainty, policy uncertainty is higher in weaker economic conditions, and synchronicity generally increases when economic conditions decline, when measured with GDP growth. These results are consistent with the theoretical predictions of Pástor and Veronesi (2013).

Furthermore, I find that stock return synchronicity between countries increases when joining the EU or the euro area, and the effect is stronger when joining the euro area. This suggests that currency integration is more important in the European financial markets than general economic integration. Joining the EU or the euro area also affects synchronicity inside the countries, but the direction of the effect depends on the country. I suggest that this may be due to differences in policy stability and the degree to which joining the EU develops the economic and financial systems in the country.

These findings show that policy uncertainty and the European integration may have important implications on the ability of investors to diversify their portfolios, on market efficiency, and on the effectiveness of corporate governance methods.