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Journal of Banking and Finance 13 (1989) 589-612.

CSFB, 2a Great Titchjeld Street, London WIP, UK
Received September 1987, final version received November 1988
This paper Investigates the relationship between stock indices, asset portfolios and macroecono-
mic variables in ten European countries It is shown that employment, imports, mflatlon and
interest rates are inversely related to stock prices. Expectations about future real activity,
measures for money and the U.S. yield curve are positively related to stock prices. A portfolio
of European stock indices was constructed and it is shown that this portfolio is the variable that
most strongly explains the variation in the stock prices. The associations between stock prices
and macroeconomic variables are shown to be strongest in Germany, the Netherlands,
Switzerland and the United Kingdom. There 1s a high degree of similarity between the effects in
the first three of these countries. In several instances the stock prices are related to historic
value of economic variables indicating that predictive models can be constructed.
1. Introduction
Participants in the financial markets are eager observers of numerous
economic figures and, according to market commentators, asset prices
regularly react to fluctuations in macroeconomic variables. However, there
are no generally accepted asset pricing models that explicitly take economic
variables into account. Returns on common stocks have a complicated
relationship to macroeconomic variables and portfolios of other assets. For
the U.S., some of these relationships were studied by Fama (19X1), Chen,
Roll and Ross (1986) and Keim and Stambaugh (1986). Chen, Roll and Ross
identified the spread between long and short term interest rates, the expected
and unexpected inflation, industrial production, and the spread between high
and low grade bonds as systematically affecting stock returns. Fama looked
at the correlation between stock returns, real activity, inflation and money.
Keim and Stambaugh studied the relations between stock returns and the
yield differential between low grade bonds and Treasury bills, the ratio of the
Standard and Poors composite index to its previous long run level, and the
level of small firms prices.
*This research was conducted at the University of Chicago. I am grateful for the comments of
Professor Robert Z. Aliber, Professor George M. Constantinides, Professor Eugene F. Fama,
Professor Victor Zarnowitz, Joe Kairys and a referee.
03784266/89/$3.50 0 1989, Elsevier Science Publishers B.V. (North-Holland)
590 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
This paper investigates the relations between a major stock index and
macroeconomic variables in ten European countries. It was found that
changes in stock prices are positively correlated to some measures of real
economic activity, in particular with future industrial production and with
exports. Positive correlations are also shown between changes in the stock
indices and the yield curve in the U.S., as well as the MI and lagged values
of the stock prices themselves. Changes in stock prices are negatively
correlated to employment, the exchange rate, imports, inflation and interest
rates. These economic variables may be representatives of state variables in
the intertemporal capital asset models (I-CAPM). Imports may be perceived
as a measure for consumption and the negative correlation between imports
and stock prices is evidence in support of the consumption CAPM. U.S.
stock prices (S&P 400) and a constructed portfolio of European indices show
strong positive correlation with the individual countries stock indices. These
two stock portfolios may, together with the macroeconomic variables, be
perceived as factors in a factor model.
The evidence is not equally strong in all countries and individual countries
may show results contrary to what is expected. In general, the strongest
relationships between the stock market and macroeconomic variables are
found in France, Germany, the Netherlands, Switzerland and the U.K. The
Dutch, German and Swiss markets react to a large extent similarly to the
various economic factors.
The remainder of the paper is organized in 9 sections. Section 2 presents
the data and discusses the statistical methodology. Section 3 looks at the
stock indices in relation to their historic values and to portfolios of other
stocks. Section 4 discusses the relationship between movements in stock
prices and measures for real economic activity and section 5 studies the
relationship between stock prices and consumption. Section 6 looks at
exchange rates, section 7 at interest rates and section 8 at inflation and
money supply. In section 9 factor models are constructed and in section 10
the results are discussed and the conclusions are drawn.
2. The data
The study uses quarterly data from 1968 to 1984 retrieved from the
International Financial Statistics Data File of May 1986. Some parts of the
study only cover France, Germany, Italy, Switzerland and the U.K. because
a broad range of national account data only exists for these countries.
Appendix 1 defines the macroeconomic variables and shows which time
series are used. In some cases the time series start later than 1968. Appendix
2 shows the stock indices that are used in the study and table 1 shows
summary statistics for the different indices.
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 591
All time series excluding the interest rate series are transformed into rates
of change by the formula In (XtjXt - 2) and measured from period to period
in order to avoid overlapping time periods which often produce serially
correlated error terms.
The regressions are performed by the ordinary least squares method and
adjusted for heteroskedasticity using the formula suggested by White (1980).
Other procedures were employed to reduce the autocorrelation of the error
term, but produced similar results. A statistical significance at the 95%
confidence level is referred to as significant later in the paper.
Interest rates and most of the stock indices are period averages. It is
plausible to use period averages because most of the markets covered are
illiquid and implementation of changes in asset allocation will take time.
However, there are limitations in average price data when predictive models
are constructed. Period averages also create a higher degree of autocorrela-
tion in the time series [see Working (1960)].
Many of the subsequent regressions have low Durbin-Watson statistics, in
particular when stock returns are regressed on only one variable. However,
the error terms are expected to be autocorrelated because this single variable
is unlikely to explain all of the changes in the dependent variable and
because of the high autocorrelation of the stock indices themselves.
In order to reduce the autocorrelated error terms, the Cochrane-Orcutt,
the maximum likelihood and the Hildreth-Lu procedures were used in some
examples. The Durbin-Watson statistics increased as expected and
approached two while the F-statistic and the r-squared were both reduced.
The sign and significance of the individual coefficients, however, showed
only minor changes.
The stability of the coefficients was checked over different time intervals
for most of the key relationships presented. In general, the outcome was the
same as for the entire period 1968 to 1984 with no systematic changes in the
size or significance of the coefficients.
The stock indices are not adjusted for dividend payments. In percentage
terms, the average yield for the ten indices varied from 3.5% in the bull
market of 1972 to 6.7% in the 1981 recession according to Morgan Stanley
International Capital Perspective. Dividends, however, show a high level of
stability over time in absolute terms, and it is the share price appreciation
and depreciation which constitute the volatile component of the stock return.
Thus, the omission of the dividend payments is not a serious problem when
the objective is to explain fluctuations in returns.
3. Portfolios of assets
Table 1 indicates that the stock indices are highly autocorrelated. Regress-
ing stock returns on those for the four previous periods gave significant
592 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 1
Summary statistics for stock prices.
INT is the quarterly interest rate on long term bonds, RETis quarterly changes in the stock
prices, var is the variance of the return on the stock indices and al, a2 and a3 are the
autocorrelation coefficients for lags of one, two and three quarters, respectively.
68-84 58-67 68-75 76-84
I NT RET var al a2 a3 RET var RET var RET var
3.2 2.9 9.2 0.57 0.30 0.09 0.9 4.8 2.2 9.3 3.5 9.3
Fin n.a. 3.5 7.8 0.31 0.29 0.27 0.2 4.3 4.4 8.4 2.7
Fra 2.4 1.5 8.6 0.23 0.0 0.12 0.1 6.8 0.8 8.8 2.0
Ger 1.9 0.7 6.0 0.28 -0.10 0.0 3.2 10.7 0.3 6.8 1.1
Ita 3.0 0.3 9.8 0.28 0.10 0.0 1.2 8.5 - 1.7 8.2 2.1
Net 2.1 1.1 7.3 0.19 -0.16 0.15 1.7 6.7 0.2 8.2 1.9
Nor 2.0 1.9 10.7 0.25 0.12 0.12 -0.4 3.9 1.0 11.0 2.7
Swe 2.3 2.8 8.4 0.36 0.13 0.04 1.6 5.0 1.7 6.9 3.7
SW1 1.2 0.6 6.4 0.20 0.05 0.18 1.0 8.2 -0.2 7.7 1.3
U.K. 2.8 2.3 10.6 0.29 -0.07 0.10 2.2 6.2 0.6 13.4 3.7
coefficients for all countries, except Switzerland. For example in Denmark
and the U.K., the r-squared figures are 0.37 and 0.16 respectively. This may
indicate that technical analysis has validity in making portfolio decisions.
However, low liquidity in many of the markets covered by the study is a
possible explanation for these results. This is particularly the case for small
countries like Denmark. In addition, these results should be interpreted with
caution since we are testing period averages.
Do U.S. stock prices have any influence on prices in the local European
markets? Regressing the national stock indices on current and past periods
returns of the S&P 400 (Standard and Poors industrial index) strongly
supports the view that the American market or conditions influencing the
American market are correlated with the local European markets. There is a
significant positive relationship between the S&P 400 and all of the markets
covered with the exception of Finland. In Denmark, Norway and Sweden
the results indicate that the stock prices may be predicted based on the last
periods prices in the U.S. market. (The results are not shown here.)
An equally weighted portfolio (or a basket) of three European indices:
Germany, Sweden and the U.K. was regressed against each individual index.
When the basket was regressed against the index of one of the countries
making up the basket itself, the index of that country was omitted from the
basket. Table 2 shows that the basket exhibits stronger correlation with
changes in stock prices in the individual countries than with the S&P 400.
This is surprising considering the preoccupation with the U.S. stock market
among many European investors. Only in Sweden and the U.K. do the U.S.
share prices have the same significance as the other European share prices
represented through the basket. In these two countries, however, the basket
is made up of only two indices.
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 593
Table 2
U.S. and European stock prices.
Changes in individual stock indices (RET) regressed on S&P 400 @US)
and a basket of European stock indices (D&W). The absolute t-values are
shown in parentheses below each coefficient.
0.78 0.30 15.1 1.10
0.41 0.04 2.5 1.42
0.41 0.22 10.4 1.53
0.42 0.38 21.6 1.63
0.26 0.10 4.7 1.41
0.24 0.03 1.9 1.50
0.84 0.62 55.4 1.68
0.30 0.18 8.2 1.56
0.55 0.51 35.6 1.50
(5.88) *
0.19 0.35 18.6 1.57
The basket of the three European indices shows the strongest correlation
to the stock prices of all the variables investigated in the study. S&P 400 and
the basket of European indices may be thought of as asset portfolios in the
sense that is discussed in Appendix 3.
4. Measures of real activity
The present value of the future net income is the central factor in
evaluating the value of a firm. In the fundamental valuation eq. (1) in
Appendix 3, the future net income is represented by the sum of the future
dividend payments, assuming that a liquidation dividend is paid. Assuming
rational markets, the asset prices should reflect expectations of these future
earnings which again are likely to be influenced by measures for real activity
in the national and international economies. In the intertemporal CAPM,
macroeconomic variables may represent state variables that change the
594 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
investors preferences over time and consequently influence the expected rate
of return. In the APT model, the factors determining the asset prices may be
represented by macroeconomic variables.
Five measures for the economic activity were looked at. They are changes
in industrial production (DIND), real gross national product @GNP), gross
capital formation (DCAPI;), employment (DEMP) and exports (DEXP).
Assuming efficient markets, it is expectations about future values of these
variables that will influence asset prices. It is difficult to obtain hard figures
for the aggregated expectations of future values of economic variables.
However, since investors form their expectation based on all currently
available information, it is reasonable to assume that the realized economic
values are unbiased estimates of the ex ante expectations. Thus, actual future
values for the periods t+ 1, t+2, etc. were used as estimates for the expected
values for future real activity at time t in order to examine how stock prices
were influenced by the expected value of real factors. Lagged values of the
variables gain importance if the investors are unable to predict future trends,
if there are disagreements of how the asset returns are impacted by the
variables or if information disseminates slowly. Under any of these circum-
stances, lagged variables can form a basis for predictive models.
Future industrial production was the most promising of the five variables
tested. Table 3 presents the results of a simple regression of changes in the
stock prices in period t on the growth in industrial production during period
t+n where IZ is 0, 1, 2, and 4. All countries, but Sweden, show at least one
significantly positive coefficient, but only the Netherlands and Switzerland
have an adjusted r-squared above 0.10. Only Germany has a significant
contemporaneous effect when the expected future growth rate, represented
by the ex post data, is taken into consideration. The data indicate that the
Dutch and the British markets are the most forward looking. The French
market also seems to discount future real activity to a large degree. An
explanation for the lack of a relationship in the Swedish data may be the
heavy export orientation of the major industrial firms in the country that
make up a large proportion of the Swedish stock market.
Past values of the growth rate in industrial production do, in general, give
negative but insignificant coefficients when regressed against the stock
market. Thus, the stock market does not react positively to information
about past growth in industrial production. This is in accordance with the
theory that the stock market reflects expectations of future events in current
prices. In Germany, the lagged growth rate is significantly inversely corre-
lated with stock returns.
Regressing the stock returns on the change in capital expenditures does
not give strong results. The stock market was regressed against current and
two future periods of capital expenditures. All countries, but Italy, had
contemporary negative coefficients, while the future periods tended to show
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 595
Table 3
Industrial production and stock prices.
Changes in the stock prices (RET) in period t regressed on changes in the industrial production
(DIND) in period t+n. The absolute t-values are shown in parentheses below the coefficients.
t+4 r-sq F-st DW
- 0.28
0.00 0.62 1.57
0.04 1.72 1.65
0.07 2.31 1.58
0.03 1.42 1.36
0.10 2.92 1.74
0.02 1.35 1.60
0.00 0.66 1.37
0.17 4.29 2.00
0.07 2.27 1.64
positive results. This is in accordance with the capital formation theory
[Fama (1981)] and with an environment where firms d&invest from the stock
market when actual investments take place. However, only England and
Italy show significant coefficients in this regression.
Changes in the stock indices were regressed on changes in exports in five
countries. When regressing the current and two lagged periods of the export
against the stock prices, four out of the five countries showed significant
coefficients on the first or second lag. The correlations were in general
strongest on the second lag indicating a predictive power of exports. (These
results are not shown here.)
One would expect employment to be positively related to real activity and
that we would consequently see a positive correlation between the stock
return and employment. In table 4, however, we see that this is not the case.
On the contrary, there is a strong negative relationship between the stock
returns and lagged values of employment. The reason may be that employ-
ment is expected to increase only in the later stages of a boom period at a
point when declining earnings are expected for most firms.
596 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 4
Employment and stock prices.
Changes m stock prices (RET) regressed on changes in employment (DEMP). The
absolute t-values are shown in parentheses below each coefficient.
CONS t t-1 t-2 r-sq F-st DW
Den 0.026
Fin 0.035
(3 57)
Fra 0.008
Ger 0.000
Ita 0.002
Net -0.013
SW1 0.003
- 1.88
- 1.27
- 2.70
- 1.59
( 1.06)
- 2.44
- 1.20
- 2.48
0.50 0.10 3.33 1.22
0.39 0.04 1.94 0.45
-0.58 0.00 1.10 1.59
0.65 0.14 4.48 1.41
- 1.15 0.00 0.96 1.41
0.60 0.15 4.82 1.57
- OJ2 0.10 3.44 1.70
Data for Nor, Swe and U.K. are not available, for the whole period.
5. Exchange rates
Depreciation of a currency improves the competitive position of domestic
industries. Both the prices and volume of their production can result in higher
profitability. Earnings brought home from foreign subsidiaries appreciate in
value are accounted for in the local currency. Thus, reported earnings for an
international or export orientated firm will increase when the currency
However, exchange rates do not change in a vacuum. The underlying
economic factors causing exchange rate changes may also effect the stock
prices. If the exchange rate changes are caused by a deteriorating domestic
economy, they should have an adverse effect on the local stock market. If
the changes on the other hand are caused by currency overshooting, the
first mentioned effect is likely to dominate and the local stock market will
benefit from the situation. In some countries, currency depreciation is often
followed by raising interest rates. It is later shown that interest rate changes
are negatively correlated to stock returns which would imply the same
relationship between exchange rates and stock returns.
The evidence about the relationship between the changing currency values
and the stock market give some support to the initial hypothesis. Using the
effective trade-weighted exchange rate, Denmark, the Netherlands, Norway
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 597
Table 5
Exchange rates and stock prices
Changes in the stock prices (RET) regressed on changes on effective trade-weighted
local/USD exchange rate (1974-1984). The absolute t-values are in parentheses below
each coefficient.
RET CONS t t-l
Den 0.023 -0.96 -0.14
(1.69) (1.58) (0.27)
Fin 0.016 0.48 -0.41
(1.53) (1.62) (0.77)
Fra 0.034 0.78 0.66
(1.98) (1.14) (1.03)
Ger 0.014 -0.01 -0.25
(1.74) (0.02) (0.85)
Ita 0.021 0.55 -0.43
(0.93) (0.95) (0.64)
Net 0.013 - 1.24 -0.02
(1.26) (3.22) (0.07)
Nor 0.002 - 0.29 -0.23
(0.11) (0.44) (0.30)
Swe 0.025 -0.69 -0.78
(2.30) (1.50) (1.26)
SW1 0.007 -0.37 0.17
(0.74) (1.44) (0.82)
U.K. 0.027 0.35 -0.52
(1.59) (1.10) (1.31)
r-q F-st DW
0.08 1.11 0.82
0.10 2.58 1.57
0.07 2.06 1.73
0.10 2.57 1.51
0.13 3.17 1.25
0.00 0.65 1.60
0.91 0.93
0.70 1.27
0.53 1.38
0.45 1.40
and Sweden exhibit a negative relation as shown in table 5. The t-statistics,
however, are not very strong.
6. Consumption
The U.K. is the only country that showed a significant negative relation
between stock prices and consumption. This is not encouraging for the
consumption CAPM which tell us that asset return is negatively correlated
to the marginal propensity to consume according to eq. (3) in Appendix 3.
However, it may be some comfort that what is perceived as the most
efficient stock market in Europe displays the expected relation.
A major problem with consumption as an explanatory factor for the
changes in the stock prices is the relative stability of consumption over time,
Thus, it is unlikely that consumption could be the only state variable in an
empirically tested intertemporal CAPM.
M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 6
Imports and stock prices.
Changes in stock prices (RET) regressed on changes in imports (DIMP). The absolute
t-values are in parentheses.
t t-1 t-2 r-q F-st DW
-0.32 - 0.40 -0.18 0.09 3.14 1.69
(1.61) (2.20) (0.77)
-0.25 -0.51 -0.16 0.07 2.55 1.48
(1.33) (2.41) (0.93)
0.38 -0.16 -0.36 0.03 1.56 1.46
(2.16) (0.79) (1.08)
0.32 -0.16 -0.36 0.04 1.92 1.72
(1.34) (0.89) (1.60)
- 0.49 -0.41 - 0.47 0.16 5.20 1.64
(2.09) (1.87) (2.02)
Looking at imports may provide an alternative avenue for studying the
consumption CAPM. Changes in imports are mainly caused by changes in
consumption and investments. As international trade grows, domestic private
consumption has become a driving force behind imports in most countries,
in particular in the smaller ones where imports make up a large proportion
of GNP. Consumer durables constitute a relatively large part of the imports
in these countries, thus imports can be expected to be more volatile over
time than consumption. Changes in imports may consequently be a good
estimator for changes in real consumption and indicate changes in the
preference for savings over time. Table 6 shows that there is a significant
negative relationship between imports and the stock market in France,
Germany, and the U.K. This supports the relationship that was found
between stock prices and consumption. Only the U.K., however, shows an
r-squared of any substantial size.
7. Interest rate
The interest rate is the denominator in the fundamental valuation eq. (1)
in Appendix 3. Thus, we expect a negative relationship between the interest
rate and the price changes in the stock market. The opportunity cost for
investors in the equity markets is represented by the short term interest rate.
In most European countries, however, good measures for the short term rate
can only be found for the last ten years. Thus we have chosen to look at the
relationship between the long term interest rate and changes in the stock
prices even though this is likely to give weaker results because of the lower
M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 7
Interest rates and stock prices.
Changes in stock prices (RET) regressed on interest rates on long term bonds
(BOND). The absolute t-values are in parentheses below each coefficient.
t-2 r-sq F-st DW
Den -0.015
Fin 0.024
Fra 0.033
Ger 0.062
Ita 0.013
Net 0.078
Nor -0.025
Swe 0.072
Swi 0.100
U.K. 0.048
-0.019 - 0.002
(2.21) (0.14)
0.002 0.002
(1.04) (1.16)
-0.017 - 0.023
(0.61) (0.60)
- 0.027 -0.006
(1.71) (0.26)
- 0.007 - 0.023
(0.33) (0.65)
-0.030 -0.033
(1.62) (1.10)
- 0.003 0.001
(0.43) (0.31)
-0.053b 0.121
(1.45) (2.18)
- 0.038 - 0.035
(1.56) (0.91)
- 0.084 0.070
(5.08) (2.70)
0.10 3.42 1.07
0.04 1.97 1.50
0.05 2.15 1.68
0.12 4.04 1.53
0.04 1.80 1.48
0.21 6.95 1.82
0.00 0.50 1.50
0.10 3.43 1.45
0.22 7.01 1.94
0.40 15.72 1.68
Indicates that the coefftcient is significantly negative if the bond yield at time t only
is regressed against the stock return.
Indicates that the coefftcient in the regression without any lag is significantly
volatility of the long term rate. This is partly caused by the fact that we only
have yield figures instead of holding period returns.
Table 7 strongly supports the hypothesis that changes in stock prices and
interest rates are inversely correlated. Again, the results are strong for
Germany, the Netherlands, Switzerland and the U.K. There is a lower, but
still significant negative relationship in Sweden. The result for Denmark is
hard to interpret because of the very low Durbin-Watson statistic.
The results for Finland, France and Norway are peculiar. However, these
have been small illiquid financial markets and the credit flows have been
highly regulated for most of the period covered by the study. In an attempt
to assess how well the long term interest rates reflected the short term rate,
we regressed the short term interest rate on the long term rate. There was a
lack of correlation between the two rates in Denmark, Finland, France,
600 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 8
Term structure and stock prices.
The changes in the national stock prices (RET) on the U.S. yield
curve (YC). The absolute t-values are shown in parentheses
below each coetXcient.
0.017 0.011
(1.09) (1.27)
0.038 - 0.002
(3.43) (0.40)
0.005 0.008
(0.42) (1.19)
- 0.009 0.013
(1.07) (2.93)
0.018 -0.011
(1.05) (1.43)
-0.007 0.016
(0.75) (2.85)
0.027 - 0.007
(1.75) (0.85)
0.023 0.004
(1.94) (0.52)
-0.010 0.014
(1.03) (2.85)
- 0.005 0.24
(0.35) (3.20)
r-sq F-st DW
0.01 1.90 0.82
0.00 0.00 1.36
0.00 1.28 1.56
0.09 7.17 1.51
0.02 2.34 1.53
0.08 6.82 1.73
0.00 0.54 1.51
0.00 0.30 1.26
0.08 6.92 1.65
0.10 8.06 1.56
Norway and Sweden. This is partly caused by poor data and probably also
by the highly regulated credit markets in these countries during most of the
period investigated.
Strong evidence from the U.S. suggests that the yield curve shifts
according to the business cycle. During economic expansions, the difference
between the yield on a long term government bond and a short term
Treasury bill is large and the yield curve is positively sloped. When the
economy is sluggish, the difference has historically been smaller and even
produced a downward sloping yield curve. We would consequently expect a
positive relationship between the slope of the yield curve and stock market.
Keim and Stambaugh show that this holds for the U.S.
The relation between the U.S. yield curve and the European stock indices
was looked at because of the lack of good European time series for short
term interest rates. The U.S. yield curve is likely to impact European asset
returns because of the influence of the U.S. economy on the European
economy. The results are shown in table 8. There is a positive correlation
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 601
between the U.S. term structure and the stock market in several countries.
Again we see that the results are similarly strong in Germany, the
Netherlands and Switzerland. These three countries and the U.K. have
adjusted r-squares close to 0.10.
8. Inflation and money supply
According to the Fisher equation, there should be a one-to-one relation
between the changes in nominal return and the expected rate of inflation,
Furthermore, shares are claims on underlying real assets and should
therefore provide a hedge against inflation.
Fama and Schwert (1977) showed that stock prices respond negatively to
current and lagged values of inflation in the U.S. Since then a number of
papers have presented evidence for an inverse relationship between inflation
and the stock return both in the U.S. and other stock markets.
Fama (1981) looks at the underlying economics in order to explain the
spurious relationship between inflation and stock return. The basis for his
test is a rational expectations combination of the money demand function
and the quantity theory of money which predicts that higher expected
growth in real activity has a negative relation to current inflation. Under the
assumption of a stable monetary policy, expectations about future growth in
the economy will increase the money demand and induce a reduction in the
inflation rate.
Geske and Roll (1983) present a fiscal policy argument instead of a
stagflation scenario and argue that stock returns and expected inflation are
negatively associated because of a chain of events. Gultekin (1983) and
Solnik (1983) conclude that there is a consistent lack of positive association
between stock returns and inflation covering several countries. Wahlroos and
Berglund (1986) find support for Famas theory in the Finnish stock market.
Several measures for inflation have been used in testing the relation
between inflation and stock returns. Fama and Gibbons (1982) constructed
measures for expected and unexpected inflation from the short term interest
rate. Fama also used the money demand inflation models and several
researchers have used ARIMA models. Last, but not least, the relation can
be studied just using past and contemporary inflation. Here, the time series
of inflation is used as measures for expected and unexpected inflation.
The inflation is highly autocorrelated over time. Thus, the rate of inflation
at time t- 1 is a good predictor for the expected rate of inflation at time t.
The ex post values of inflation at time t will contain both the unexpected
change in inflation and the expected change not explained in the inflation
rate at time t - 1. Past values of inflation are therefore viewed as a measure
602 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 9
Past inflation and stock prices.
Changes in stock prices (RET) regressed on changes in the price level (DINF). The
absolute t-values are in parentheses below each coefficient.
t-2 r-sq F-st DW
Den 0.010
Fin 0.097
Fra 0.063
Ger 0.031
Ita 0.00
Nor 0.070
Net 0.060
Swe 0.008
Swi 0.003
U.K. 0.005
-1.50 -0.87 -0.90
(1.88) (1.13) (1.29)
- 0.48 -0.18 - 1.97
(0.49) (0.15) (2.48)
0.63 -0.44 - 2.41
(0.3 1) (0.19) (1.39)
0.01 0.09 -2.24
(0.01) (0.06) (1.99)
- 1.08 2.25 - 1.10
(1.08) (2.06) (1.03)
-0.061 -1.86 -0.13
(0.68) (2.18) (0.13)
0.15 0.09 - 3.52
(0.17) (0.08) (3.80)
0.80 0.56 -0.34
(0.91) (0.69) (0.43)
- 1.51 -0.30 -0.71
(1.52) (0.28) (0.66)
1.08 0.16 -0.60
(0.83) (0.14) (0.55)
0.04 1.94 0.82
0.10 3.45 1.59
0.05 1.11 1.51
0.02 1.44 1.46
0.01 1.24 1.33
0.00 0.98 1.52
0.11 3.70 1.61
0.00 0.40 1.24
0.03 1.70 1.78
0.03 0.60 1.36
The 4th lag becomes positive when the stock return is regressed on the first four
lags of the inflation.
for expected rate of inflation. The rate of inflation at time t represent both
expected and unexpected rate of inflation.
In table 9 the change in stock prices is regressed on the change in the
current and two lagged values of the price level. Denmark, Finland,
Germany, the Netherlands, and Norway all show one or more coefficient
that indicates a significantly negative relationship, while the results for
France and Switzerland are close to being significant. The second lag of
inflation is generally most often significant. This indicates that changes in the
expected rate of inflation are more important than changes in unexpected
inflation in explaining the spurious relation between inflation and stock
prices. Only Finland and the Netherlands, however, exhibit adjusted r-
squared above 0.10. Thus, on a stand alone basis, inflation does not have
much potential explanatory power for the changes in stock prices.
Because of the stability of inflation over time, it is reasonable to assume
that a large part of the changes in future inflation are expected changes.
Thus it is interesting to investigate the relationship between future values of
M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 10
Inflation and stock prices.
Changes in stock prices (RET) regressed on changes in inflation
(DINF). Absolute t-values are in parentheses below each coefficient.
t-l-2 r-sq F-st DW
Den 0.045 -0.67 0.54
(1.87) (0.75) (0.06)
Fin 0.087 -1.77 -0.50
(3.96) (1.66) (0.36)
Fra 0.071 - 1.34 - 1.24
(2.59) (0.71) (0.64)
Ger 0.045 -0.60 -2.98
(3.15) (0.54) (2.70)
Ita -0.001 0.23 -0.09
(0.07) (0.2 1) (0.09)
Net 0.051 -0.44 - 2.28
(2.32) (0.35) (1.85)
Nor 0.089 -2.25 - 1.27
Swe 0.077 - 1.46 -0.87
(3.60) (1.72) (1.02)
Swi 0.044 - 2.02 -1.48
(3.81) (2.79) (2.18)
U.K. 0.062 1.51 -3.11
(2.30) (1.01) (2.31)
0.22 0.86
3.91 1.53
1.60 1.53
4.50 1.51
inflation and changes in the stock indices. If investors successfully fo&ast
inflation, we expect a negative relationship between stock returns and future
inflation. Table 10 shows that there is actually a stronger correlation
between stock returns and future inflation, than between stock returns and
values for current and past inflation. The largest changes in the explanatory
power of inflation when it leads rather than lags stock prices, occurs in
Germany, the Netherlands and United Kingdom. The signs of the coeffC
cients are more consistently negative when inflation leads the stock prices
than when it lags. Generally, however, the signs are the same in both
Firth (1979) showed that there is a significant positive connection between
inflation and stock returns in the U.K. The evidence shown in table 9 does
not contradict his result. This is peculiar since the U.K. has the largest and
probably the most efficient equity market in Europe. The results in table 10,
however, where the inflation half a year into the future is negatively
correlated with the current period stock prices, indicates that the British
might not be so peculiar anyway. They may just possess superior predictive
604 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 11
Money supply and stock return.
Changes in the stock prices (RET) regressed on measures for money supply (DMO, DMl, DM2).
The values shown are the sum of the three coefficients of the regression t, t- 1, and t-2.
DMO r-sq F-st DW DMl r-sq F-st DW DM2 r-sq F-st DW
-0.66 0.00 1.10 1.54 -0.30 0.00 0.61 1.47 -0.85 0.00 0.86b 1.49
-0.45 0.01 1.27 1.39 1.08 0.12 4.04b 1.54 1.13 0.10 3.54b 1.32
-0.82 0.01 0.75 1.49 0.56 0.00 1.06 1.41 0.31 0.00 0.85 1.40
1.07 0.17 5.60b 1.72 0.38 0.19 6.0gb 1.56 -1.89 0.25 8.31b 1.60
Swi 0.24 0.03 1.75 1.57 0.86 0.13 4.30b 1.71 0.79 0.00 1.17 1.69
U.K. -0.70 0.05 2.26 1.38 1.58 0.07 2.62b 1.49 -1.22 0.03 1.62b 1.34
Indicates that all three coefficients have the same sign.
bIndicates that at least one of the three coefficients is significant at the 95% level.
The figures for the Scandinavian countries are not recorded because of highly autocorrelated
error terms. To the degree that the coefftcients showed any sign of significance, they generally
showed the same pattern as above.
Inflation and money supply are related according to most economic theory
and we would consequently expect some relationship between money supply
and stock returns. The quantity theory of money indicates that increased
money supply results in increased inflation, holding real activity and velocity
of money constant. Thus, higher money supply should create expectations
about higher inflation.
Table 11 shows the relationship between different measures for money
supply and the stock prices. The monetary base, MO, is generally shown to
have a negative relationship to the stock prices. The evidence however, is
only significant in the U.K. For the Netherlands, there is actually a strong
positive effect.
The broader measures for the money supply show a stronger relationship
with the stock prices than the monetary base. The results are significant for
Germany, the Netherlands, Switzerland, and the U.K. The positive coefli-
cients indicate that there is a liquidity effect at work where the overriding
effect of changing monetary supply is to increase the liquidity in the financial
markets. The increased liquidity is transferred into demand for financial
assets which results in higher return on stocks. Higher demand for bonds
decreases the interest rate. The interest rate was earlier shown to have a
negative relation to the stock prices which supports the liquidity argument.
Fama and Schwert showed that expectations about inflation works
through the Fisherian equation to increase the nominal return on govern-
ment bonds. A higher interest rate increases the discount factor in the
fundamental valuation eq. (1) in Appendix 3. Consequently, this argument
should counteract the liquidity effect outlined above. The evidence, however,
suggests that the liquidity effect is strongest.
Friedman and Schwartz (1963) showed that the money supply leads
business cycles. We have shown that stock prices and real economic activity
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 605
Table 12
Inflation, interest rate, money supply and stock prices.
Changes in stock prices (RET) regressed on changes in the price level INF( -2), changes
in the money supply @Ml), and the interest rate (BOND). The absolute t-values are in
parentheses below the coefficients.
RET CONS DMl(-1) BOND I NF( -2) r-sq F-st DW
Den - 0.024
Fin 0.075
Fra 0.043
Ger 0.069
Ita - 0.027
Net 0.145
Nor - 0.002
Swi 0.124
U.K. 0.085
0.925 0.004
(1.54) (1.43)
0.216 0.006
(1.94) (3.03)
0.225 0.003
(0.71) (0.76)
0.189 0.006
(1.16) (1.17)
0.280 0.002
(1.34) (0.53)
0.087 -0.010
(0.65) (2.03)
0.336 0.005
(2.15) (1.30)
0.372 - 0.027
(2.55) (2.72)
0.516 -0.008
(1.29) (1.15)
- 1.079
- 1.67
- 3.364
- 1.706
0.048 2.12 0.96
0.216 7.06 1.64
0.027 1.61 1.49
0.063 2.48 1.46
0.00 0.74 1.43
0.15 4.91 1.64
0.054 2.26 1.46
0.196 6.37 1.82
0.00 0.86 1.50
are positively correlated. Thus, this is poten&illy another explanation for the
positive relation between money supply and stock price.
We have seen that stock prices have mgative correlation with both
inflation and interest rates and that there is a;positive relation between stock
prices and a broad measure of money. In-table 12, the changes in stock
prices are regressed on these three monetary variables. It is interesting to
note that the evidence is similar for the; three countries making up the
European hard currency area: Germany, the Netherlands and Switzerland.
However, the significance of the results decreases for Germany when changes
in the stock index is regressed on the three variables simultaneously. We also
see that the monetary variables have a strong explanatory power for the
changes in stock prices in Finland.
The evidence shown in table 12 indicates that inflation is negatively
correlated with the stock prices in several countries even after the money
supply is added to the equation. The U.S. data presented by Fama shows
that the explanatory power of the expected inflation disappears when the
stock return is regressed both on the money base and expected inflation.
9. Factor models
Table 13 shows the changes in the stock prices regressed on all the
J B F.-E
606 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
Table 13
Stock prices, asset portfolios and macroeconomic variables.
Changes in stock prices (RET) regressed on different asset portfolios and macroeconomic
variables. Absolute t-values are in parentheses.
RET Independent variables r-sq DW
0.002+0.49RET( - 1) +0.70DESH
(0.28) (5.78) (5.53) 0.54 2.12
0.030-2.33 DINF( -2)+0.38DESH( -2)+
(1.50) (3.77) (2.98)
1.11 DM2(-2)+0.54DXRA( -2)+0.24RET(-1)
(3.29) (2.38) 0.43 2.29
(0.72) (4.24) (2.72) 0.27 1.65
0.073+0.34DESH -2.08 DEMP( - l)-0.011 BOND+0.41 DM2( - 1)
(2.06) (3.77) (3.14) (2.61) (2.25) 0.47 1.87
0.016+0.61DUS-0.48 YC+O.O33 YC(-1)
(1.15) (3.55) (3.65) (2.49) 0.24 1.94
(1.43) (9.43) (3.51) (3.59) (2.10) 0.71 1.97
0.042- 1.34DM2 +0.42 RET( - 1) +0.45 DESH
(2.73) (4.12) (3.90) (2.43) 0.30 2.05
(2.48) (3.45) (3.30) (3.61) (2.33) 0.35 1.65
0.025 + 0.61 DESH - 0.024 BOND - 0.04 DEXP( - 1) - 1.32 DEMP( - 1)
(4.34) (6.73) (4.45)
(2.37) 0.62 2.14
(1.00) (5.46) (3.24) (2.47) (2.34) (2.01) 0.49 1.76
variables discussed previously in the paper. The explanatory variables in
table 13 are chosen by a stepwise procedure that adds variables to the
equation depending on their F-statistics. The equations do not necessarily
represent the combinations of independent variables that best explains the
variability in stock. The independent variables are included in the equations
if their t-values are above two.
The equations in table 13 may be thought of as a factor model according
to the discussion in Appendix 3. The portfolio consisting of the British, the
German and the Swedish stock indices (DESH) shows up as an explanatory
variable in seven countries. Different measures for money supply (DM) are
important in six countries. These two factors are by far the most significant
in a cross country comparison. Last periods changes in stock prices
(RET(- l)), the change in U.S. stock prices @Us) and changes in the
exchange rate (DXRA), each are important in three countries. Inflation
(DCPI), the U.S. term structure (YC), interest rate (BOND) and employ-
ment (DEMP) are of consequence in two countries each.
M. Asprem, Stock prices, asset portfolios and macroeconomic variables
10. Conclusion
The evidence presented in this paper show that employment, imports,
inflation and interest rates are negatively correlated to stock prices. Changes
in imports may be viewed as an indicator for changes in consumption. Thus,
the relation between imports and stock prices is evidence in support of the
consumption capital asset pricing model. The negative correlation between
inflation and stock prices can be explained through a combination of the
money demand theory and the Fisherian quantity theory of money.
The stock indices in most of the ten countries covered in this study show a
high positive correlation between the S&P 400 (S&Ps industrial index) and
the stock indices. However, the correlation to a basket of European indices
was even stronger.
A positive relation between the yield curve in the U.S. and the local stock
prices is discovered as well as between the broader measures for money
supply and the stock prices and in some countries between the exchange
rates and the stock prices. The positive correlation with money supply
implies that monetary liquidity is important for stock pricing. The evidence
also shows that movements in stock prices lead measures for real activity,
indicating that stock markets make rational expectations about future
In addition to the country-specific variables, inflation, industrial produc-
tion and money supply for the industrial countries as were tested against
stock indices in the individual countries. In general, the significance and the
explanatory power of these aggregated variables did not attain the level of
their local counterparts.
It is unreasonable to believe that only one economic factor will exhaust
possible explanations for movements in stock prices. Most intertemporal
asset pricing models suggest that more parameters are important in asset
pricing. In table 13, changes in the national indices are regressed on the
different economic variables investigated in this study. We observe that the
explanatory power of the equations increases substantially compared to when
the stock prices were regressed on the individual variables. Not surprisingly,
the autocorrelation in the error terms also disappears.
Different capital asset pricing models are derived and discussed in
Appendix 3. The covariance term in eq. (4) may represent covariance
between the return on an individual asset and the return of asset portfolios.
It may also represent covariance between the return on an asset and
different macroeconomic variables.
If the return on an individual asset only is correlated with the market as a
whole, the covariance term in eq. (4) has a similar interpretation as the beta
in the S-L CAP&f. However, other portfolios may be constructed from
subsets of the market portfolio and these may show different relationships to
608 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
the return on individual assets. The S&P 400 and the constructed European
basket presented in this paper, are other such subsets of the market. They
may be viewed as two of two or more portfolios to which the Merton inter-
temporal CAPM relates return on an individual asset.
The different relationships detected between changes in the national stock
indices and macroeconomic variables are examples of the covariance term in
(4). From the perspective of the intertemporal CAPM, changes in macroeco-
nomic variables are important because they alter the preference for con-
sumption over time.
Several relationships detected indicate that there is a link between past
values of macroeconomic variables and changes in stock prices. The factor
models in table 13 show many significant coefficients for lagged values of
economic variables. A regression of the stock indices on past values of the
variables yielded r-squared values between 0.2 and 0.4 for all countries with
the exception of Italy and France. These preliminary results indicate that it
takes time before the stock market fully reacts to news about changes in
economic variables. Further exploration of these relationships may discover
opportunities for building predictive models that yield returns above that of
the market.
This study has tested the relationships between a large number of variables
and the stock indices by using quarterly data. For individual variables it is
possible to obtain time series with more frequent data points which probably
would produce stronger results when regressed against stock prices than
those discovered here.
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 609
Appendix 1: List of variables
Variable IMF line
34 & 35
6Oc & 61
s-t interest rate; starting end of
70s for most countries
yield on long term government bond
private gross fixed capital formation
private consumption
trade-weighted exchange rate, MERM, quoted
employment, seasonally adjusted
equally weighted portfolio of the German,
Swedish and U.K. stock indices.
real gross national expenditures; line 99b,
GDP, is used for Fra, Ita and Swi
industrial production
consumer price index
reserve money
money and quasi-money
U.S. share prices; S&P 400
long term interest rate
change in stock prices
difference between U.S. bond and T-bill rate
Variables starting with a D and RET are continuously compounded
quarterly changes.
Appendix 2: Stock indices used in the study
United Kingdom:
end-of-month quotations of a sample of industrial
shares on Copenhagen SE
daily average buying quotations on Helsinki SE
end-of-week quotations of 180 shares on Paris SE
daily averages covering 95% of quoted industrial
daily averages of closing prices of 40 major companies
on Milan SE
daily average of 55 general shares on Amsterdam SE
mid-month prices of Oslo SE General Index
end-of-month prices of all shares on Stockholm SE
Friday quotations of 49 industrial shares in
Zurich, Geneva and Base1
daily average of 500 industrial ordinary shares
Appendix 3: Capital asset pricing models
In the traditional Sharpe-Lintner capital asset pricing model (S-L CAPM),
asset returns are determined by mean-variance mathematics. The rate of
return on an asset is determined by the risk-free rate, rf (or, in the Black-
610 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
model, the rate of return on the minimum-variance zero-beta portfolio that is
uncorrelated with the market), the market return, rm and the covariance
between the returns on the individual asset and those on the market divided
by the variance of the market returns. This is a one-period equilibrium
model. In a multi-period setting, we would have to assume that the risk-free
rate and the market return are constant (or at least non-stochastic) in order
to use the S-L CAPM. Empirically, however, it is clear that neither rf nor rm
are constant over time.
A realistic multi-period model has to take into account the changes in the
state of the economy over time. Merton (1973) derived an inter-temporal
asset pricing model (I-CAPM) where the asset returns depend on the
covariances between the individual asset and a set of state variables in
addition to the covariances between the returns on the asset and those on
the market portfolio. In this model, investors choose portfolios to hedge
against changes in the state variables. The state variables may be thought of
as macroeconomic factors. The investors are, for example, assumed to be
interested in hedging against inflation in their portfolio decisions.
In the following, three capital asset pricing models, consumption CAPM
(C-CAPM), S-L CAPM and I-CAPM, are derived using the techniques of
Constantinides (1986). These derivations show the basic differences between
the models in a simple way.
Constantinides derives the C-CAPM by starting with the fundamental
valuation equation where the price of an asset is determined by the marginal
propensity to consume and the cash flow generated by the firm:
Pit=E[;iTl (z)DiT:It].
Pit is the price of the ith asset at time t, u is a von Neumann-Morgenstern
utility function, the subscript c indicated the first derivative and Di is the
dividend of the ith form. I denotes the information and : It indicates that the
expression is conditioned on the information set at time t. The expression in
the inner parentheses is the discount factor. Defining the rate of return as
Rit = (Pit + Dit)/Pit - 1 we have
Dividing both sides by Pit - 1, using the definition of Rit and defining the
excess rate of return as ri = Ri- Rf where Rf is the risk free rate,
M. Asprem, Stock prices, asset portfolios and macroeconomic variables 611
Constantinides gets the expression
The inner brackets reduces to uct. Using Steins lemma, which states that
cov(x,g(y)) = E[g(y)] * cov(x, y) assuming that x and y are normally distri-
buted, the valuation equation becomes:
E[rit] = ( - E[ucct]/E[uct]} * cov(rit, Ct),
where everything is conditioned on It - 1 and Ct is consumption in t. The
ratio in the curly brackets on the right-hand side of the equation is a
measure of risk aversion. The larger the risk aversion, the lower the expected
returns on all assets. In a one-period context, consumption equals aggregated
wealth, C= q because the investors consume all of their wealth in period
t = 1. In this case eq. (2) collapses to the traditional one-period S-L CAPM:
E[rit] = { - E[uwwt]/E[uwt]} * cov(rit, wt).
The ratio in the brackets becomes a non-asset-specific constant. The
covariance term can be written as
cov(w1, ril) = [{cov((wl - wO)/wO, ri))/(var ((wl - wO)/wO)}l
* var((w1 - wO)/wO).
The variance term is a constant and the expression in the large parentheses
represents the beta in the S-LCAPM. Thus, we see that the return as defined
in (3) is proportional to beta. The risk aversion term in (3) is not readily
observable, but multiplied by the constant in the covariance term it may be
thought of as the difference between the market premium and the risk free
rate in a one period setting.
In an inter-temporal setting the model assumes that the risk aversion term
is determined by the information in the consumption time series. However,
not all relevant information needed for determining the state of the economy
may be reflected in the changes in consumption itself. This happens if
ct(lt - 1, st) is different from ct(Zt), where st is a vector of state variables. If
that is the case, we need to include more state variables in our information
set. In doing so we get the following general valuation equation
E[rit]={ -E[ucct] *cj/E[uct]) *cov(sjt,ct),
where j is an index representing different factors. This is the Merton
612 M. Asprem, Stock prices, asset portfolios and macroeconomic variables
I-CAPM where the asset return is dependent on changes in at least one state
variable in addition to (or instead of) consumption. The consumption
CAPM initially presented by Breeden (1979) may be thought of as Mertons
intertemporal model where the information in all the different state variables
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