Expected Macroeconomic Conditions and Market Risk Premium: Evidence from a Term Structure of Macroeconomic Forecasts

Ti Zhou obtained his PhD in Finance from Hong Kong University of Science and Technology. Currently, he works as an assistant professor at School of Business, Southern University of Science and Technology. His research interests include empirical asset pricing, option pricing, and financial risk management. He teaches undergraduate- and graduate-level courses such as financial derivatives, quantitative investment, and financial econometrics. His research is supported by Shenzhen Science and Technology Innovation Commission.

We construct an expected macroeconomic condition factor from survey-based forecasts of future macroeconomic activities, with the purpose of tracking the equity premium. This macro factor exhibits salient counter-cyclical dynamics, produces an out-of-sample R2 of 3.4% for predicting quarterly stock market excess returns from 1984 to 2018, and dominates a wide array of commonly used macro and financial predictors. Relative to the short-term macro forecasts, the long-term macro forecasts provide incremental information about the time variations of long-horizon equity premiums. A dynamic trading strategy that employs market timing in return and volatility jointly based on the factor can yield a significant and sizable utility gain to a mean-variance investor. Our evidence reveals a direct and tight link between the ex-ante expectation of the macroeconomic condition and the time variation of the equity premium at the business cycle frequency. The driving force of the predictive power stems from a cyclical component of the equity premium that negatively covaries with expected macroeconomic conditions, especially during recessions.