Time Varying Risk Premia and the Output Gap

Abstract

The output gap, a production based macroeconomic variable, is a strong predictor of US stock returns. It is a prime business cycle indicator that does not include the level of market prices, thus removing any suspicion that returns are forecastable due to a "fad" in prices being washed away. The output gap forecasts returns both in-sample and out-of-sample and it is robust to a host of checks. We show that the output gap also has predictive power for excess stock returns in other G7 countries and US excess bond returns.

Keywords: return predictability, risk premia, output gap

JEL Classification: G12, G14, E44