Equity Returns and the Business Cycle: The Role of Supply and Demand Shocks
The price of aggregate risk in the UK appears to have risen significantly since the start of the financial crisis and the associated extended recession. This paper examines the relationship between the business cycle and equity market returns to see how robust this association is. Several classifications of UK business cycle quarters are examined and related to the returns from an investment strategy which buys the market one or more quarters after a business cycle quarter and holds it for one year. OÂ¢cial business cycle dating methods as well as identified structural macroeconomic shocks are examined. The findings are that there is clear evidence for countercyclicality in excess returns. Returns are significantly higher in the year following a recession rather than an expansion quarter. There is also a significant difference in the pattern of returns if the downturn in the quarter is the result of a supply or demand shock. Negative supply shocks are found to have an especially large and signicant counter cyclical impact on returns.
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