The impact of (global) business cycle risk on the German and British stock markets: Evidence from the first age of globalization

• DOI: http://doi.org/10.1016/j.rfe.2013.04.003
• Published date: 01 September 2013
• Author: Thomas Nitschka
• Date: 01 September 2013

The impact of (global) business cycle risk on the German and British

stock markets: Evidence from the first age of globalization

Thomas Nitschka ⁎

Monetary Policy Analysis, Swiss National Bank, Börsenstrasse 15, P.O. Box CH-8022 Zurich, Switzerland

abstractarticle info

Article history:

Received 19 December 2012

Received in revised form 8 April 2013

Accepted 9 April 2013

Available online 16 April 2013

JEL Classifications:

E32

F44

G15

Keywords:

Business cycle

Globalization

Industrial production

Predictability

Stock market

In the period from 1880 to 1913, time-varying German and British stock market returns are related to busi-

ness cycle variables such as the deviation of industrial production from trend. Common British and German

business cycle dynamics Granger cause stock returns and explain more than 20% of time variation in one-year

ahead stock market returns. The link between business cycle variables and stock returns is less pronounced in

the modern era of financial globalization. A potential explanation for this finding is the fact that during the

first globalization period stock indices were dominated by industrial companies and stock prices varied in

line with dividends. In the modern era of globalization stock price dynamics predominantly reflect

time-varying risk premia.

© 2013 Elsevier Inc. All rights reserved.

1. Introduction

Theoretical and empirical research emphasizes that global risk fac-

tors play an important role in explaining stock market returns' time

variation (Campbell & Hamao, 1992; Cooper & Priestley, 2013;

Ferson & Harvey, 1993; Guo, 2006; Harvey, 1991; Nitschka, 2010,

2012). This evidence is typically interpreted as sign of integrated

stock markets.

In addition, basic asset pricing theory suggests that time variation

in asset returns as well as their cross-sectional dispersion should be

related to macroeconomic risk factors (e.g. the survey by Cochrane,

2005). A variety of studies have found that macroeconomic variables

are informative about the future path of stock market returns (Lettau

& Ludvigson, 2001; Lustig & Van Nieuwerburgh, 2005; Piazzesi,

Schneider, & Tuzel, 2007; Santos & Veronesi, 2006). A recent example

is Cooper and Priestley (2009) who show that the deviation of indus-

trial production (production gap) or output from trend (output gap)

predicts excess returns on the U.S. stock and bond market in-

and out-of-sample. A negative production gap today predicts high

(excess) returns on stock markets in the next period.

This paper argues that the time period from 1880 to 1913 provides

the ideal sample to assess if these findings hold “out-of-sample”. First,

as e.g. Flandreau and Zumer (2004) highlight, the period from 1848 to

1914 can be characterized as the first age of financial globalization.

Hence, national stock market returns could be driven by global risk

factors. Second, if global risk drives time variation in asset returns,

then it should be reflected in macroeconomic variables because theo-

retical asset pricing models stress the link between variation in risk

aversion over the business cycle and time-varying asset returns (e.g.

Campbell & Cochrane, 1999; Constantinidis, 1990). Data on business

cycle variables, such as output or industrial production, and stock

market indexes for at least some countries are readily available.

The main results of this paper highlight that the dynamics of the

German and British stock markets in the period from 1880 to 1913 in-

deed reflect the impact of business cycle related risk. Following

Nitschka (2012), this paper shows that stock market returns are relat-

ed to past periods' common variation in British and German produc-

tion gaps. This finding holds for real and excess returns. As in the

modern era of globalization, industrial production gaps today signal

future stock market returns but stock market returns do not indicate

future production gaps (Nitschka, 2012).

Is the link between stock markets and business cycles comparable

with the current time period of financial globalization? This paper

evaluates this question by comparing the predictive ability of the

same set of business cycle variables for the German and British

stock market in the period from 1980 to 2011 with the evidence

from the first age of globalization. It turns out that the link between

the business cycle variables and time variation in stock market

returns was stronger during the first age of globalization than in the

Review of Financial Economics 22 (2013) 118–124

⁎Tel.: +41 44 6313628.

E-mail address: thomas.nitschka@snb.ch.

1058-3300/$ –see front matter © 2013 Elsevier Inc. All rights reserved.

http://dx.doi.org/10.1016/j.rfe.2013.04.003

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