The macro-finance environment and asset allocation: A simultaneous equation approach

We propose a novel methodology to identify latent factors influencing investment allocations in financial assets. By drawing logical paths in a structural equation model (SEM) framework, we uncover the role of a latent return factor that simultaneously shapes the dynamics of different financial assets. Our methodology allows for disentangling the different components of asset returns - those driven by fundamental and non-fundamental variables. We apply this methodology to Euro-area stocks and sovereign bonds over the 2003-2014 period. Lower economic and political uncertainty in Europe triggers a trade-off towards stocks and away from bonds, while U.S. Quantitative Easing boosts European stocks. (C) 2016 Elsevier Inc. All rights reserved.