The Linkage between Equity Returns and Government Responses to the Disease Outbreak

This study examines regime switches in the empirical relation between stock market returns and government stringency indices, which reflect the extent of policy responses to the new coronavirus outbreak. The analysis is based on the Oxford Covid-19 Government Response Tracker, which reflects several indicators of governmental responses ranging from workplace and school closures, to movement restrictions, and income support. The evidence from Markov-regime switching models for the Japanese and U.S. markets suggests that the dynamics of market returns are dominated by regimes governed by mean reversion and negative correlation with changes in the model-free volatility index. The negative relationship between changes in volatility expectations and market returns seems to be robust to different Markov regimes. The relationship between returns and changes in government stringency index is more likely to be associated with the expected negative sign, but it remains rather weak. Markov regimes where the impact of government responses on market returns is found to be statistically significant, are indeed less likely to prevail. The evidence lends support to the proposition that the return-generating process is insensitive to the serious economic effects of the disease outbreak. The important question remains as to whether in addition to their impact on currency markets, quantitative and qualitative easing programs are also conducive to the impairment of the price discovery process in financial markets.