Empirical Analysis of the Link between Politics and Stock Market Behaviour Thesis submitted for the degree of Doctor of Philosophy at the University of Leicester By Xun LEI School of Business University of Leicester March 2018 Empirical Analysis of the Link between Politics and Stock Market Behaviour Xun Lei Abstract Political risk factors have become an important source of systematic and non- systematic risk in capital markets. From a micro perspective, policy risk and political connections are widespread in different countries. Therefore, how to effectively manage the political risks has become an increasing concern for researchers and investors. Politics is a broad and complex subject, and financial scholars have studied it from many perspectives. This thesis consists of three empirical studies that focus on three specific political aspects and investigate how these aspects affect stock market performance. The first empirical chapter examines how economic policy uncertainty (EPU) is related to stock market performance in the U.S. I find that an increase in the EPU index negatively affects S&P500 returns and increases its implied volatility. Furthermore, the component of the EPU index that has the strongest explanatory power is that based on newspaper coverage of policy uncertainty, while the other three lack statistical significance. Governments should try to maintain policy stability and sustainability, so that investors can make reasonable predictions about policy changes and arrange their investment planning accordingly. Moreover, investors should also pay attention to expectations of policy change and adjust their portfolios based on policy uncertainty exposure. The second empirical chapter examines the impacts of democracy improvement on stock markets from an international perspective. The empirical results suggest that increases in political rights lead to higher stock returns. Investors might seek investment opportunities in democratic countries’ markets. For policy makers, improving economic institutions is not the only way to attract foreign investment and promote capital market development, reforming the political regime is also worth thinking about. The third empirical chapter conducts a textual analysis on U.S. presidential speeches to examine the influence of political communications on stock market. Presidential speeches reflect the president’s and advisers’ views on the country's future economy, and may also contain new information related to future policy directions. This study employs content analysis techniques and an event study method to analyse the market response to the linguistic characteristics of the presidents’ addresses. The results show a significant and positive association between the level of commonality expressed in a president’s speech and abnormal returns on the DJIA around the speech date. This implies that peaceful speeches are associated with a statistically significant increase in abnormal returns. These findings suggest that as well as analysing the specific content of public political information, its linguistic features and emotional tendencies are also worthy of investors’ attention. I Acknowledgments My sincere thanks must go to many people without whose help this thesis would not have been completed. First of all, my special gratitude goes to my supervisors, Dr Tomasz Piotr Wisniewski and Professor Emmanuel Haven. I particularly express my deepest and sincere gratitude to my first supervisor Dr Wisniewski for his inspiring guidance and consistent encouragement, constructive and enlightening suggestions without which this thesis would not be materialized. The quality of this work would have been undermined without his kind perusal. I am intellectually indebted to Dr Wisniewski who was always ready to discuss matters relating to this study and provided valuable comments and suggestions on how to improve the content of my research. His comments on chapter drafts are themselves a course in critical thought upon which I will always draw. His serious scholarship and academic practise, and above all, his agreeable personality, have influenced me immensely. Further, I would like to offer my sincere thanks and appreciation to the staff of School of Business, University of Leicester for their various supports. My heartfelt thanks should go to my schoolmates, whose warm encouragement and caring comfort gave me confidence in fulfilling this thesis. I also wish to thank to the whole Chinese community in Leicester. My country mates have always been supporting and encouraging to me. They helped me a lot in making my life easier and comfortable in Leicester. Last but not least, I am deeply indebted to my dear parents for their endless support. They have always been a source of encouragement and strength for me. Without their consistent support and inspiration, I might not have been able to accomplish this task. II Table of Contents ABSTRACT........................................................................................................................................... I ACKNOWLEDGMENTS ................................................................................................................... II LIST OF FIGURES ............................................................................................................................ VI LIST OF TABLES ............................................................................................................................ VII I. INTRODUCTION ............................................................................................................................. 1 1.1 INTRODUCTION ...................................................................................................................... 1 1.2 THE RESEARCH QUESTIONS ................................................................................................... 3 1.3 SUMMARY OF MOTIVATIONS AND CONTRIBUTIONS ............................................................... 4 1.4 STRUCTURE OF THE THESIS .................................................................................................... 9 II. THEORETICAL BACKGROUND AND LITERATURE REVIEW ....................................... 10 2.1 THEORIES OF POLITICAL BUSINESS CYCLES ......................................................................... 10 2.1.1 Introduction .................................................................................................................... 10 2.1.2 Basic theories .................................................................................................................. 12 2.1.3 Models with rational agents ............................................................................................ 15 2.1.4 Summary ......................................................................................................................... 19 2.2 FROM MACROECONOMICS TO FINANCIAL MARKETS ........................................................... 22 2.2.1 Fiscal policy .................................................................................................................... 22 2.2.2 Political cycles in financial markets ............................................................................... 24 III. ESSAY ONE: POLICY UNCERTAINTY AND STOCK MARKET...................................... 27 3.1 INTRODUCTION .................................................................................................................... 27 3.2 POLITICS, UNCERTAINTY AND FINANCIAL MARKETS ........................................................... 30 3.2.1 Political uncertainties and financial markets ................................................................. 31 3.2.2 Policy uncertainty and financial markets........................................................................ 38 3.3 THEORETICAL ANALYSIS ..................................................................................................... 42 3.4 HYPOTHESES DEVELOPMENT ............................................................................................... 44 3.5 DATA ................................................................................................................................... 45 3.5.1 Sample ............................................................................................................................. 45 3.5.2 Variable definitions ......................................................................................................... 47 3.5.3 Summary statistics and correlation matrix ..................................................................... 52 3.5.4 Test of stationarity .......................................................................................................... 56 3.6 EMPIRICAL ANALYSIS .......................................................................................................... 56 3.6.1 Modelling stock market returns ...................................................................................... 57 3.6.2 Modelling stock market implied volatility ....................................................................... 62 3.7 FURTHER DISCUSSION .......................................................................................................... 66 3.7.1 Analysing characteristics portfolio ................................................................................. 66 3.7.2 Influence on cash flow and discount rate ........................................................................ 70 3.8