Inflation Shocks and Equity Vulnerability: Regime, Sign, and Cross-Country Asymmetries in the G7

This paper investigates the nonlinear and state-dependent relationship between inflation surprises and real equity returns across G7 economies. Using monthly data from January 1998 to May 2025, we employ nonlinear local projection models to estimate the dynamic responses of the equity market to domestic inflation shocks. While linear estimates reveal modest but persistent average losses, once regime dependence and sign asymmetry are jointly considered, three critical findings emerge. First, equity responses are strongly regime-dependent: inflation shocks occurring in high-inflation environments produce losses two to four times larger than those in low-inflation regimes. Second, the direction of the shock matters: positive inflation surprises are associated with deeper and longer-lasting equity declines than the gains generated by negative surprises. Third, these effects exhibit pronounced cross-country heterogeneity, with distinct vulnerability profiles that remain invisible in linear or pooled models. To systematically assess these differences, we develop a Sensitivity–Volatility–Vulnerability (SVV) assessment that synthesizes regime-dependent and sign-asymmetric responses into market vulnerability profiles. Our results underscore that inflation risk in equity markets is not only nonlinear and regime-dependent but also fundamentally country-specific, implying that conventional linear models materially understate downside equity exposure. These findings carry important implications for monetary policy, financial regulation, and international portfolio diversification.