POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit

 
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
POLITICS AND ASSET PRICES

                         L’uboš Pástor

        University of Chicago, Booth School of Business
                   National Bank of Slovakia
                        CEPR, NBER

2020 Bank of Finland Workshop on Finance and Politics, August 2020
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
Overview

1. Partisan effects: Democrats vs. Republicans
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Political cycles and stock returns, Journal of
     Political Economy, forthcoming.

2. Rise of populism: Backlash against globalization
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Inequality aversion, populism, and the backlash
     against globalization, Working paper, University of Chicago.

3. Political uncertainty
   • Pástor, Ľuboš, and Pietro Veronesi, 2012, Uncertainty about government policy and stock
     prices, Journal of Finance 67, 1219–1264.
   • Pástor, Ľuboš, and Pietro Veronesi, 2013, Political uncertainty and risk premia, Journal of
     Financial Economics 110, 520–545.
   • Kelly, Bryan, Ľuboš Pástor, and Pietro Veronesi, 2016, The price of political uncertainty:
     Theory and evidence from the option market, Journal of Finance 71, 2417–2480.
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
Overview

1. Partisan effects: Democrats vs. Republicans
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Political cycles and stock returns, Journal of
     Political Economy, forthcoming.
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
Overview

1. Partisan effects: Democrats vs. Republicans
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Political cycles and stock returns, Journal of
     Political Economy, forthcoming.

2. Rise of populism: Backlash against globalization
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Inequality aversion, populism, and the backlash
     against globalization, Working paper, University of Chicago.
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
Overview

1. Partisan effects: Democrats vs. Republicans
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Political cycles and stock returns, Journal of
     Political Economy, forthcoming.

2. Rise of populism: Backlash against globalization
   • Pástor, Ľuboš, and Pietro Veronesi, 2020, Inequality aversion, populism, and the backlash
     against globalization, Working paper, University of Chicago.

3. Political uncertainty
   • Pástor, Ľuboš, and Pietro Veronesi, 2012, Uncertainty about government policy and stock
     prices, Journal of Finance 67, 1219–1264.
   • Pástor, Ľuboš, and Pietro Veronesi, 2013, Political uncertainty and risk premia, Journal of
     Financial Economics 110, 520–545.
   • Kelly, Bryan, Ľuboš Pástor, and Pietro Veronesi, 2016, The price of political uncertainty:
     Theory and evidence from the option market, Journal of Finance 71, 2417–2480.
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
Political Cycles and Stock Returns

                       Ľuboš Pástor ∗

                               and

                      Pietro Veronesi ∗∗

             Journal of Political Economy, forthcoming

∗
    University of Chicago, National Bank of Slovakia, NBER, CEPR
                ∗∗
                   University of Chicago, NBER, CEPR
POLITICS AND ASSET PRICES - L'uboˇs P astor CEPR, NBER University of Chicago, Booth School of Business National Bank of Slovakia - bofit
Average Excess Stock Market Returns

             30

             20

             10
% Per Year

              0

             -10

             -20

             -30
                                                                Democratic Presidents
                                                                Republican Presidents

              1927   1935    1944   1953   1962   1971   1980     1989   1998   2007   2015
Average Excess Stock Market Returns, % Per Year

                  Democrat   Republican   Difference
1927:01–2015:12    10.69        -0.21      10.90
                   (4.17)      (-0.07)     (2.73)
Average Excess Stock Market Returns, % Per Year

                   Democrat   Republican   Difference
1927:01–2015:12     10.69         -0.21      10.90
                    (4.17)       (-0.07)     (2.73)
Average Excess Stock Market Returns, % Per Year

                   Democrat   Republican   Difference
1927:01–2015:12     10.69         -0.21      10.90
                    (4.17)       (-0.07)     (2.73)

1927:01–1971:06     10.80         -0.20      11.00
                    (2.83)       (-0.03)     (1.58)
1971:07–2015:12     10.52         -0.22      10.74
                    (3.46)       (-0.06)     (2.24)
Average Excess Stock Market Returns, % Per Year

                   Democrat   Republican   Difference
1927:01–2015:12     10.69         -0.21      10.90
                    (4.17)       (-0.07)     (2.73)

1927:01–1971:06     10.80         -0.20      11.00
                    (2.83)       (-0.03)     (1.58)
1971:07–2015:12     10.52         -0.22      10.74
                    (3.46)       (-0.06)     (2.24)

1927:01–1956:08     12.58         -1.89      14.46
                    (2.51)       (-0.20)     (1.37)
1956:09–1986:04      5.94          1.38       4.57
                    (1.62)       (0.37)      (0.85)
1986:05–2015:12     11.99         -0.99      12.98
                    (3.49)       (-0.21)     (2.17)
• Sample period: 1927-1998
Average Excess Stock Market Returns, % Per Year

                  Democrat   Republican   Difference
1927:01–1998:12    10.52        1.15       9.38
                   (3.54)      (0.32)     (2.05)
Average Excess Stock Market Returns, % Per Year

                  Democrat   Republican   Difference
1927:01–1998:12    10.52        1.15       9.38
                   (3.54)      (0.32)     (2.05)
1999:01–2015:12    11.37        -6.02     17.39
                   (2.48)      (-0.91)    (2.14)
Our Story
Our Story

• Election outcomes are endogenous
  – Democrats get elected when expected returns are high
  – Republicans get elected when expected returns are low
Our Story

• Election outcomes are endogenous
  – Democrats get elected when expected returns are high
  – Republicans get elected when expected returns are low

• Time-varying risk aversion
  – Risk aversion high ⇒ Elect Democrats (D)
  – Risk aversion low ⇒ Elect Republicans (R)
    ∗ So risk premia are high under D, low under R
Our Story

• Election outcomes are endogenous
  – Democrats get elected when expected returns are high
  – Republicans get elected when expected returns are low

• Time-varying risk aversion
  – Risk aversion high ⇒ Elect Democrats (D)
  – Risk aversion low ⇒ Elect Republicans (R)
    ∗ So risk premia are high under D, low under R

• Risk aversion ↑ ⇒ Less willingness to take business risk
                    More demand for a social safety net
                 ⇒ Elect party promising more redistribution (D)
                                                                                                                                 

                                                                                                                                             
1       2           3       4       5   6   7       8    9   :                       ;           2       <       =       8       >   9       ?

!       "       #   $       !       %               &       '        (   )   *   '   +       #   +       ,       -       .       /           +       0   +
N   O           P       Q           R   S       T   U       V       W                   X   O       Y       Z       U       [   V       \

@           A   B       C       D   E           F           G       B       E   H   I   J           J       K       L       C           B       M   A   B
Our Contribution

• Develop a new model of political cycles
  – Agents with heterogeneous skill, time-varying risk aversion
  – Agents choose occupations, vote in elections
    ∗ Democrats: Big government, high taxes
    ∗ Republicans: Small government, low taxes
Our Contribution

• Develop a new model of political cycles
  – Agents with heterogeneous skill, time-varying risk aversion
  – Agents choose occupations, vote in elections
    ∗ Democrats: Big government, high taxes
    ∗ Republicans: Small government, low taxes

• First model that generates the presidential puzzle

• Model also predicts
  – Political cycles arise naturally: Democrats vs. Republicans
  – Higher GDP growth under Democrats
  – Public sector votes Democrat, private sector Republican
Model Overview

• Beginning of period t:
  – Risk aversion γt drawn
                                      
                                        Entrepreneur
                          Occupation: Government worker
                         
                         
  – Agents born, choose           
                                   High-tax
                         
                          Party:
                                   Low-tax
  – Entrepreneurs start firms, invest, trade

• End of period t:
  – Firms produce output Yi,t+1, pay taxes and dividends
  – Agents consume Ci,t+1, die
h       i   j       k   l       m       n   o   p   q   r   s   t   u   l

                    v   w           x   y       z       {

]   ^   _   `   a                                                                               b   c   d   d   e   f   g
Solution

• All agents are rational, making utility-maximizing choices of
  – Who to vote for (Democrat or Republican)
  – Which occupation to choose (Entrepreneur or Government Worker)
Solution

• All agents are rational, making utility-maximizing choices of
  – Who to vote for (Democrat or Republican)
  – Which occupation to choose (Entrepreneur or Government Worker)

• Proposition:
  All entrepreneurs vote Republican (party L).
  All government workers vote Democrat (party H).
Solution

• All agents are rational, making utility-maximizing choices of
  – Who to vote for (Democrat or Republican)
  – Which occupation to choose (Entrepreneur or Government Worker)

• Proposition:
  All entrepreneurs vote Republican (party L).
  All government workers vote Democrat (party H).

• Proposition:
  An agent becomes an entrepreneur iff her skill is large enough.
Government           Entrepreneurs
workers

                 k
             _                  i
G           E

        L
    _           i
G       E

        H
    _       i
Always G       E under L           Always E
               G under H

               L               H
           _               _                  i
Equilibrium

• Proposition: There exist two thresholds γ < γ such that

                                                       1
  1. For γt > γ, there is a unique equilibrium: mt <   2
                                                           and party H wins
                                                       1
  2. For γt < γ, there is a unique equilibrium: mt >   2   and party L wins

  3. For γ < γt < γ, there are two equilibria:
                                                        1
   (a) If agents believe party H will win, then mt <    2
                                                          and H wins
                                                       1
   (b) If agents believe party L will win, then mt >   2
                                                          and L wins
Implications for Stock Returns

• Expected stock market return:
                        Et (Rt+1) = γtσ 2

• Proposition: If γt fluctuates sufficiently so that at least one
  of γt < γ and γt > γ occurs with nonzero probability, then
                                                  
             E Rt+1 | τt = τ H > E Rt+1 | τt = τ L
Implications for Growth

• Proposition: Private sector productivity is higher under H.

• Proposition: Under sufficient complementarity between pub-
  lic & private sectors, expected growth is higher under party H.
Implications for Growth

• Proposition: Private sector productivity is higher under H.

• Proposition: Under sufficient complementarity between pub-
  lic & private sectors, expected growth is higher under party H.

                Average GDP Growth, % Per Year

                         Democrat    Republican    Difference
      1930:01–2015:12       4.86         1.70        3.16
                           (4.87)       (1.96)      (2.40)
Endogenous Risk Aversion

• Link γt to the state of the economy:
  – Risk aversion ↑ when economy weak, ↓ when strong
Endogenous Risk Aversion

• Link γt to the state of the economy:
        – Risk aversion ↑ when economy weak, ↓ when strong

• Political cycles arise naturally:
                                                            ˆ   €   ~       ‰           ‡       ƒ   „   Š           ‰       †
                                                                                                                                        |       }       ~          €              ‚       ƒ       ~   }       „       ‹   „   Š

Œ   €   ƒ   ‰                 Š           }       ~

                                                                                                                                                                                                                            Œ       €   ƒ   ‰      Ž   Š   }   ~

                                                                                                                                    
                        |   }       ~          €              ‚       ƒ       ~   }       „               †   }       ‡       †           ‹       „       Š           ‡       ƒ       „       Š           ‰       †
Who Are the Democratic Voters?

                  U.S. Democratic Voters              UK Labour Voters
Risk Aversion  0.13 0.12       0.12     0.12     0.14 0.14       0.16     0.14
              (7.28) (6.04) (5.89) (5.40)       (8.23) (5.23) (4.77) (3.72)
Entrepreneur          -0.28 -0.25      -0.15            -0.40 -0.41      -0.39
                     (-5.68) (-5.04) (-2.65)           (-7.83) (-6.38) (-4.95)
Gov’t Worker                  0.19      0.12                    0.22      0.26
                             (3.39) (1.95)                     (4.07) (3.99)
Income                                 -0.03                             -0.10
                                      (-3.47)                          (-12.86)
Education                               0.26                              0.44
                                     (13.30)                            (7.94)
Age                                    -0.01                             -0.01
                                      (-4.50)                           (-4.83)
Gender (Male)                          -0.62                             -0.16
                                     (-11.62)                           (-3.02)
Observations   8855 7809 7771          6784     30301 12626 7949         6279
Inequality Aversion, Populism, and
      the Backlash Against Globalization

                       Ľuboš Pástor ∗

                               and

                      Pietro Veronesi ∗∗

∗
    University of Chicago, National Bank of Slovakia, NBER, CEPR
                ∗∗
                   University of Chicago, NBER, CEPR
Overview

• Our model is motivated by the backlash against globalization
  in rich western democracies (Brexit, Trump, etc.)
Overview

• Our model is motivated by the backlash against globalization
  in rich western democracies (Brexit, Trump, etc.)

• Pushback against globalization emerges endogenously
  – Rational voters’ optimal response to rising inequality
Overview

• Our model is motivated by the backlash against globalization
  in rich western democracies (Brexit, Trump, etc.)

• Pushback against globalization emerges endogenously
  – Rational voters’ optimal response to rising inequality
Overview

• Our model is motivated by the backlash against globalization
  in rich western democracies (Brexit, Trump, etc.)

• Pushback against globalization emerges endogenously
  – Rational voters’ optimal response to rising inequality
  – Globalization carries the seeds of its own destruction
Economic Mechanism

Global growth
    ⇓       (heterogeneous risk aversion)
Inequality ↑
    ⇓       (inequality aversion)
 Backlash
Economic Mechanism

          Global growth
               ⇓       (heterogeneous risk aversion)
           Inequality ↑
               ⇓       (inequality aversion)
            Backlash

• Backlash = Elect a populist, Globalization → Autarky
  – Consumption ↓ but equality ↑
Model Overview

• Agents live in one of two countries, US or RoW
• Agents dislike risk and inequality in their own country
  – Inequality aversion ≈ anti-elitism, “envy of the rich”
Model Overview

• Agents live in one of two countries, US or RoW
• Agents dislike risk and inequality in their own country
  – Inequality aversion ≈ anti-elitism, “envy of the rich”
• U.S. agents are less risk-averse than RoW agents
  – Interpretation: U.S. more financially developed than RoW
Model Overview

• Agents live in one of two countries, US or RoW
• Agents dislike risk and inequality in their own country
  – Inequality aversion ≈ anti-elitism, “envy of the rich”
• U.S. agents are less risk-averse than RoW agents
  – Interpretation: U.S. more financially developed than RoW
• Two possible regimes:
  1. Globalization: Cross-border trade allowed (global risk sharing)
  2. Autarky: Cross-border trade not allowed (local risk sharing)
Model Overview

• Agents live in one of two countries, US or RoW
• Agents dislike risk and inequality in their own country
  – Inequality aversion ≈ anti-elitism, “envy of the rich”
• U.S. agents are less risk-averse than RoW agents
  – Interpretation: U.S. more financially developed than RoW
• Two possible regimes:
  1. Globalization: Cross-border trade allowed (global risk sharing)
  2. Autarky: Cross-border trade not allowed (local risk sharing)
• Both countries hold elections decided by the median voter
  1. Mainstream candidate: Keep globalization
  2. Populist candidate: Move to autarky
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
• Low-γi agents grow disproportionately rich over time
  – Benefits of growth accrue increasingly to “elites”
  – The ranks of elites shrink over time
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
• Low-γi agents grow disproportionately rich over time
  – Benefits of growth accrue increasingly to “elites”
  – The ranks of elites shrink over time
• Inequality grows with output, driven by elites’ consumption
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
• Low-γi agents grow disproportionately rich over time
  – Benefits of growth accrue increasingly to “elites”
  – The ranks of elites shrink over time
• Inequality grows with output, driven by elites’ consumption
• U.S. inequality is lower under autarky than under globalization
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
• Low-γi agents grow disproportionately rich over time
  – Benefits of growth accrue increasingly to “elites”
  – The ranks of elites shrink over time
• Inequality grows with output, driven by elites’ consumption
• U.S. inequality is lower under autarky than under globalization
• When output grows high enough, the populist wins U.S. election
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
• Low-γi agents grow disproportionately rich over time
  – Benefits of growth accrue increasingly to “elites”
  – The ranks of elites shrink over time
• Inequality grows with output, driven by elites’ consumption
• U.S. inequality is lower under autarky than under globalization
• When output grows high enough, the populist wins U.S. election
  – Move to autarky =⇒ Consumption ↓ but also inequality ↓
Equilibrium Results

• High-γi agents choose consumption less sensitive to shocks
• Low-γi agents grow disproportionately rich over time
  – Benefits of growth accrue increasingly to “elites”
  – The ranks of elites shrink over time
• Inequality grows with output, driven by elites’ consumption
• U.S. inequality is lower under autarky than under globalization
• When output grows high enough, the populist wins U.S. election
  – Move to autarky =⇒ Consumption ↓ but also inequality ↓
  – Output ↑ =⇒ Marginal utility ↓ =⇒ Equality dominates
    ∗ Equality is a luxury good
Other Predictions

• U.S. runs a current account deficit, RoW runs a surplus.

• Predictions for asset prices:
  – Global market share of U.S. stocks ↑ before the populist win
  – U.S. bond yields fall before the populist victory

• Cross-country empirical evidence supports the model
  – Countries are more populist if they have more inequality, more
    financial development, and current account deficits
Political Uncertainty

• Pástor and Veronesi (2012, 2013) develop GE models featuring
  – “Quasi-benevolent” government making policy choices
    ∗ Government with economic and non-economic motives
  – Uncertainty about government policy
    1. What is the government going to do?
    2. What is the impact of its actions going to be?

• JF 2012: Focus on announcements of policy changes
• JFE 2013: Focus on political news prior to policy changes
Main Results of Pástor and Veronesi (JF 2012)

• Government tends to change its policy after downturns
Main Results of Pástor and Veronesi (JF 2012)

• Government tends to change its policy after downturns

• Stock prices rise at announcements of policy decisions, on avrg
Main Results of Pástor and Veronesi (JF 2012)

• Government tends to change its policy after downturns

• Stock prices rise at announcements of policy decisions, on avrg

• Stock prices fall at announcements of policy changes, on average
  – Prices rise if the old policy was sufficiently unproductive,
    but they fall on average (in expectation)
  – Distribution of announcement returns is left-skewed
Main Results of Pástor and Veronesi (JFE 2013)

• First model in which political news moves asset prices

• Political uncertainty commands a risk premium
  – This premium is larger in poorer economic conditions
Main Results of Pástor and Veronesi (JFE 2013)

• First model in which political news moves asset prices

• Political uncertainty commands a risk premium
  – This premium is larger in poorer economic conditions

• Political uncertainty reduces the value of the “put protection”
  that the government implicitly provides to the market

• Political uncertainty raises stock volatilities and correlations
The Level of Stock Prices: Economic vs Political Shocks

           3
                   New risky policy more likely
                   New policies equally likely
                   New safe policy more likely

          2.8

          2.6
    M/B

          2.4

          2.2

           2

          1.8
          −0.02   −0.015      −0.01        −0.005        0          0.005   0.01   0.015   0.02
                                               Economic conditions (ĝt )
The Equity Risk Premium and Its Components

                                              A. Risk Premium and Its Components
                         6
                                                                                               Capital shocks
                         5                                                                     Impact shocks
                                                                                               Political shocks
      Percent per year

                         4

                         3

                         2

                         1

                  0
                 −0.02       −0.015   −0.01     −0.005        0          0.005          0.01     0.015        0.02
                                                    Economic conditions (ĝt )

                                              B. Probability of Adopting Given Policy
          100
                                                                                               Old policy
                   80                                                                          New risky policy
                                                                                               New safe policy

                   60
Percent

                   40

                   20

                  0
                 −0.02       −0.015   −0.01     −0.005        0          0.005          0.01     0.015        0.02
                                                    Economic conditions (ĝt )
Electoral Uncertainty

• Uncertainty associated with election outcomes
• Special case of policy uncertainty:
  – Elections ⇒ Governments ⇒ Policies

• Two alternative interpretations of the PV (2013) model:
  – Government decides which policy to adopt
    ∗ Uncertainty about which policy will be chosen
  – Voters decide which government to elect
    ∗ Uncertainty about which government will be elected

• Kelly, Pástor, and Veronesi (JF 2016) estimate the price of this
  uncertainty from option prices
Main Results of Kelly, Pástor, and Veronesi (JF 2016)

• Political uncertainty is priced in the option market

• Options whose lives span political events tend to be more expensive.
  Such options offer valuable protection against
  – price risk
  – tail risk
  – variance risk
 associated with major political events

• This protection is more valuable
  – when the economy is weaker
  – when political uncertainty is higher
Put Implied Volatility

                                                         IV no event
                                                         RV no event

                                                   VRP

20   25   30          35                40   45   50
                 Moneyness (|∆|)
Put Implied Volatility

                                                         IV no event
                                                         RV no event
                                                         IV event
                                                         RV event

                                                   VRP

20   25   30          35                40   45   50
                 Moneyness (|∆|)
Put Implied Volatility

                                                         IV no event
                                                         RV no event
                                                         IV event
                                                         RV event

                                                   VRP

20   25   30          35                40   45   50
                 Moneyness (|∆|)
Put Implied Volatility

                                                         IV no event
                                                         RV no event
                                                         IV event
                                                         RV event

                                                   VRP

20   25   30          35                40   45   50
                 Moneyness (|∆|)
Conclusions

• Overview of recent research on asset pricing and politics

• Topics covered:
  – Democrats vs. Republicans
  – Rise of populism
  – Political and electoral uncertainty

• Much more to be done!
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