Time-Varying Risk Premiums and Economic Cycles

Abstract

Asset returns are not correlated with the business cycle but are primarily caused by the economic cycles. To validate this claim, economic cycles are first rigorously defined, namely the classical business cycle and the growth cycle, better known as the output gap. The description of different economic phases is refined by jointly considering both economic cycles. It improves the classical analysis of economic cycles by considering sometimes two distinct phases and sometimes four distinct phases. The theoretical influence of economic cycles on time-varying risk premiums is then explained based on two key economic concepts: nominal GDP and adaptive expectations. Simple dynamic investment strategies confirm the importance of economical cycles, especially the growth cycle, for euro and dollar-based investors. At last, this economic cyclical framework can improve strategic asset allocation choices.