The Causal Impact of Macroeconomic Uncertainty on Expected Returns

I quantify the causal effect of macroeconomic uncertainty on time-varying expected returns. Due to the comovement of many countercyclical variables at monthly and quarterly frequencies, isolating exogenous changes in uncertainty proves difficult. Thus, previous approaches have imposed strong structural assumptions to disentangle the effect of uncertainty. Here I achieve clean identification with fewer structural assumptions by moving to a higher frequency. Using daily measures of macroeconomic uncertainty and expected equity market returns, I exploit the exogenous timing of macroeconomic announcements as an instrument for uncertainty. I find that macroeconomic uncertainty falls significantly on announcements. This announcement resolution of uncertainty causes a significant decrease in expected returns. My results suggest that, under weak assumptions, macroeconomic uncertainty can account for at most 35% of the daily variation in expected returns. Moreover, I provide suggestive evidence that no expected return drivers other than macroeconomic uncertainty move on announcements. Under this stronger assumption, I conclude that macroeconomic uncertainty accounts for 12% of the variation in expected returns and that a one standard deviation increase in the level of macroeconomic uncertainty causes a 185 basis point increase in expected returns.