Return predictability with endogenous growth

The component of the volatility of total factor productivity (TFP) that is orthogonal to the dividend price ratio is shown to have long-run predictive ability for excess market returns. This finding implies that TFP volatility should also predict real cash flows and/or real interest rates: it is found to mainly predict real cash flows through inflation. A model with endogenous growth, Epstein-Zin preferences and price rigidities reconciles both TFP volatility-driven long-run predictability and its real implications. Within the model, we justify the similar (to that of TFP volatility) predictive ability of a low-frequency notion of market volatility as well as the cross-sectional pricing of TFP volatility risk in alternative asset classes.

Automated summary

The volatility of total factor productivity (TFP) has long-term predictive ability for excess market returns, mainly through its ability to predict real cash flows through inflation. A model with endogenous growth, Epstein-Zin preferences, and price rigidities explains the long-term predictability driven by TFP volatility and its implications for the real economy.