Fiscal Uncertainty and Time-Varying Expected Market Returns

This study examines the predictive ability of fiscal policy uncertainty (FPU) for future stock market excess returns. We show that FPU is a strong positive predictor of returns both in-sample and out-of-sample, outperforming a range of leading financial and macroeconomic predictors as well as alternative uncertainty measures. Its forecasting power is highly asymmetric: it is concentrated almost exclusively in high-FPU periods, while being negligible during low-FPU regimes. This asymmetry translates into substantial economic gains for investors, with significant improvements in certainty-equivalent returns and Sharpe ratios occurring only in high-FPU states. Return decomposition within a present-value framework shows that FPU's predictive power stems from both cash-flow and discount-rate channels. Further analysis indicates that FPU shocks are closely associated with future economic conditions, shifts in systematic risk, and investor behavior, thereby providing an economic foundation for its predictive power.