Economic Policy Uncertainty,Inflation And Stock Market Valuation

We find there is a successful valuation method which we call the Wind model in A-share market: investors compare the P/E ratio with the inverse of nominal interest rate.Wind model is similar to Fed model popular in American stock market,which implies that dividend yield(or earning yield)is correlated with inflation.However,inflation is a nominal variable and stock yield is a real variable.They should be independent of each other.Some domestic literatures explain the positive correlation between stock yield and inflation by money illusion hypothesis,proxy hypothesis and so on.However,we argue that this relationship can be explained through the rational channel of economic policy uncertainty.On the one hand,relevant theoretical and empirical results show that the increase of economic policy uncertainty will increase equity risk premium(Bloom,2014;Brogaard and Detzel,2015;Chen Guojin et al.,2018).On the other hand,economic policy uncertainty will affect inflation(Bloom,2009;Istref and pilot iu,2014),and even positively correlate with inflation.Therefore,when the increase of equity risk premium is caused by the increase of economic policy uncertainty,stock yield will rise,and accompanied by high inflation,stock yield and inflation will change in the same direction.The reverse is true.In order to test the explanatory ability of the above rational channel,we conduct an empirical study based on the framework of Campbell and Vuolteenaho(2004)and the test strategy of Bekaert and Engstrom(2010).We decompose nominal bond yield and dividend yield.Then we re-decompose equity risk premium to separate the rational part of equity risk premium affected by economic policy uncertainty.We examine the explanatory power of economic policy uncertainty by judging the contribution of the covariance between the rational part related to economic policy uncertainty and inflation to the covariance of stock yield and nominal bond yield.At the same time,we test the influence of proxy hypothesis and money illusion hypothesis.Based on the overall data of A-share market from January 2002 to December2018,the empirical results show that economic policy uncertainty plays a leading role in the phenomenon that stock yield and inflation move in the same direction in A-share market,and its explanatory power is much greater than money illusion hypothesis.Proxy hypothesis is not valid.