Equity Returns and the Business Cycle: the Role of Supply and Demand Shocks

Abstract

The equity premium in the UK has 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 returns to see how robust this association is. Using official business cycle dating and identified structural macroeconomic shocks, evidence is found for counter‐cyclicality in excess returns. Negative supply shocks are found to have an especially large and significant counter‐cyclical impact. A long sample of realized returns using revised data and a sample of expected returns using real‐time data show similar results suggesting similarity in realized and expected returns.