Oil and G7 Equity Index Return Predictability: The Importance of Disentangling the Shocks Embedded in Oil Price Changes

Abstract

Using data until 2015, we document that oil price changes no longer predict G7 country equity index returns, as has been documented based on earlier sample periods. We use a structural VAR approach to obtain an oil price change decomposition into an oil supply shock, a global demand shock, and an oil-specific demand shock and argue that these three shocks should have different effects on equity markets. The conjecture that oil supply shocks and oil-specific demand shocks (global demand shocks) predict equity returns with a negative (positive) slope is supported by the empirical evidence over the 1986-2015 period. The results are statistically and economically significant and do not appear to be consistent with time-varying risk premia.