Equity Returns, Bond Spreads, and Economic Activity in Emerging Countries

Abstract

While simultaneously accounting for the effects of sovereign and corporate bond spreads, we document that emerging market economy (EME) equity returns have a strong predictive power for future output growth and account for a significant fraction of output fluctuations in these countries. Our results are based on the environment of Caballero, Fernandez, and Park (2019), who show that corporate bond spreads are a better driver of EME economic activity than sovereign bond spreads. We find that equity returns, a proxy of domestic and external financial conditions, play a more important role for EME output growth than both types of bond spreads. We attribute this difference to the effectiveness of equity returns in transmitting global financial risk shocks to EMEs and to the role of equity issuance in international capital flows in EMEs.