Prices and Returns: What Is the Role of Inflation?

52 Pages Posted: 29 Oct 2019 Last revised: 31 May 2023

See all articles by Yulong Sun

Yulong Sun

University of Science and Technology of China (USTC) - Department of Statistics and Finance; Bocconi University - Department of Finance

Date Written: November 20, 2018

Abstract

We find that the market dividend yield and earnings yield can positively predict future inflation for international portfolios. The inflation predictability of price ratios could invert the standard asset pricing predictive results. For example, dividend yields forecast nominal returns (but not nominal dividend growth) and real dividend growth (but not real returns). We extend the analysis to the earnings yield as a robust analysis and document a similar predictive pattern. Further term structure analysis suggests that the financial ratio variation decomposition also differs significantly in nominal and real terms. In nominal-term decomposition, discount rate news is found to be the primary contributor to variations in price ratios while in real-term decomposition, cash flow news plays a more significant role, with its importance increasing over longer investment horizons. Our study utilizes consistent inflation predictability evidence in advanced economies to re-evaluate the global relationship between price ratios and inflation. We confirm that inflation is an international state variable in post-1970s samples and that the correlation between inflation and price ratios can almost entirely be attributed to expected inflation and future growth prospects. This finding offers an explanation for the previously puzzling correlation between the dividend-price ratio and future inflation.

Keywords: Inflation predictability; International equity markets; Long-horizon regressions; Financial ratios; Hypothesis tests.

JEL Classification: G10, G15

Suggested Citation

Sun, Yulong, Prices and Returns: What Is the Role of Inflation? (November 20, 2018). Proceedings of Paris December 2019 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3475423 or http://dx.doi.org/10.2139/ssrn.3475423

Yulong Sun (Contact Author)

University of Science and Technology of China (USTC) - Department of Statistics and Finance

No.96 Jinzhai Road
Hefei, Anhui 230026
China

HOME PAGE: http://sites.google.com/view/yulongsun/

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

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