Inflation and Earnings Uncertainty and Volatility Forecasts

Abstract

When investors are highly uncertain about future values of fundamentals, their expectations tend to react more swiftly to news, affecting both variances and covariance of asset returns. Since fundamental uncertainty does not typically resolve quickly, asset volatilities and their cross correlations become predictable. We test these predictions on stocks and bonds volatilities by constructing measures of uncertainty about future inflation and future earnings growth from survey data and from estimating an equilibrium model that allows for time varying uncertainty. About half the variation in the volatility of Treasury bond returns and the covariance between stock and bond returns can be forecast at horizons of one and two years ahead. Investors using such forecasts for asset allocation purposes are willing to pay economically significant fees to improve upon other forecasting variables. JEL Classification Code: G10, G11, G12, G14

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