Macro factors driving returns - Growth, Inflation, and commodity prices

 

What drives equity returns? A simple principal component analysis applied to large cap stocks finds that the top three components can explain 27% of the variation in daily stock returns. These factor components can be matched with macro factors which can tell us what key macro variables to watch. See "Three macroeconomic factors to watch in equity markets" from the Dallas Fed. The longer paper attached to the Fed posting looks at more localized drivers of stocks, but the macro story is very attractive. 

The first principal component is associated with economic growth and is similar to the market beta. It can explain about 22.5% of the variation There is a .54 correlation between growth and factor 1. The second principal component is associated with inflation, specifically PPI. The third principal component is associated with commodity prices, either the GS commodity index or Brent oil prices. The second and third components explain just over 2% each of the return variation. The data show that the variation explained by macro factors has increased significantly from 10% to 30% of the variation.

Having a sense of macro conditions are important when looking at equity return variation. Surprises in growth, inflation, and commodity prices will have a strong impact on any diversified portfolio.