The world business cycle and expected returns

We study the predictability of stock returns using a pure macroeconomic measure of the world business cycle, namely the world's capital to output ratio. This variable tracks variation in expected stock returns in a group of the major industrial economies in the presence of world financial market-based predictor variables. The world's capital to output ratio exhibits strong out-of-sample predictive power in almost all countries studied. This is in contrast to financial market-based variables that almost never have out-of-sample forecasting power. Using the stock return predictability that we uncover, we find that international versions of conditional asset pricing models perform well. The world capital to output ratio also predicts bond returns, interest rate changes, and credit spreads. The results highlight the importance of world business conditions for financial markets.