Mindset of Finance

This paper tests whether innovations in macroeconomic variables are risks that are rewarded in
the stock market. The aggregate economy is captured with two dynamic states - inflation and real
economic activity, extracted from 11 observed macroeconomic series using the maximum likelihood
method joint with Kalman filter. The economic shocks are defined as the difference between the
ex post filtering updates on the states of economy and their ex ante expectations.

The conditional covariances between excess returns on a large cross section of stock portfolios and the economic shocks are estimated using bivariate GARCH models. Then, the system of equations are estimated with a common slope coefficient between excess returns and their conditional covariance with the economic shocks.

The results indicate a significantly negative (positive) relation between the portfolio returns
and their conditional covariance with the inflation-related (output-related) shocks. These findings are robust to different portfolio formations, alternative specifications of the conditional covariance, and different distributional assumptions for innovations in returns and macroeconomic variables.