Industry-level stock returns volatility and aggregate economic activity in Australia

Drawing upon rationales from the theories of investment and consumption under uncertainty and the models of sectoral reallocation, we assess the implications of industry-level stock returns volatility for the future state of the Australian economy in terms of real Gross Domestic Product (GDP) growth, inflation and unemployment. By explicitly modelling the cyclical pattern of industry-level volatility and relating it to corresponding cyclical behaviour of macroeconomic variables, we show that industry-level volatility is a leading indicator of the movements in output growth and inflation. We find complementary evidence from a Vector Autoregression (VAR) based multi-step Granger causality test and impulse response analysis. However, the forecast error variance decompositions suggest that although the industry-level volatility accounts for a significant fraction of the forecast error of inflation, this explains only a small fraction of output and unemployment uncertainties. Further analysis indicates that industry-level volatility contains better information about the future state of the economy than does aggregate stock market volatility