When and Why Do Stock and Bond Markets Predict Economic Growth?

We consider whether key financial variables predict macroeconomic series and if any predictive power for output growth is also seen in consumption or investment growth. Such information will allow the use of financial markets as a leading indicator for macroeconomic performance. Full sample results suggest that aggregate stock returns and the 10-year minus 3-month term structure exhibit a positive and significant predictive effect on subsequent output, consumption and investment growth. Additionally, the change in the 3-month Treasury bill has predictive power for output and investment growth. Sub-sample analysis reveals that while the term structure exhibits relatively constant predictive power that arising from stock returns largely only occurs during the great moderation period, whereas for the change in the short-term rate it largely arises in the period following the financial crisis. Results also reveal similarity in the predictive relations for output growth and investment growth but less so for consumption growth. We extend the analysis to include commodity, housing and the corporate bond markets. Full sample results reveal limited additional predictive ability, while the REIT returns do provide positive predictive power for output and investment growth over a one-quarter horizon, with the default return doing likewise at the four-quarter horizon. Notably, sub-sample results reveal a change in the sign of the predictive coefficient around the dotcom bubble and crash period.