Leading Indicator Information in UK Equity Prices: An Assessment of Economic Tracking Portfolios
Bank of England Working Paper No. 137
24 Pages Posted: 23 Jul 2001
Date Written: May 2001
An economic tracking portfolio (ETP) is a portfolio of financial assets whose returns are correlated with some macroeconomic variable of interest. Specifically, an ETP is designed to track revisions to investors' expectations about the target macroeconomic variable. This paper evaluates whether ETPs provide information about expectations of future macroeconomic outcomes, and are thus a useful tool for conjunctural economic assessment. A set of ETPs is estimated using UK equity returns for three target variables: inflation, industrial production growth, and growth in the volume of retail sales. In sample, it is possible to track all three of the target variables with equity returns. But the out-of-sample results are poor. Although some ETPs retain significant explanatory power, most do not, and in all cases there is a substantial deterioration in the relationship between the ETPs and the target variables. Covariances between equity returns and macroeconomic variables appear to change substantially over time, and the consequent instability in portfolio weights significantly diminishes the usefulness of ETPs for conjunctural analysis.
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