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Credit Conditions and Expected Stock and Bond Returns

Recently, an active academic debate has arisen over whether any economic variables predict future excess stock returns better than historical average excess returns. Goyal and Welch (2008) argue that many predictive variables used in the literature perform poorly both in sample and out-of-sample, especially over the last 30 years. In contrast, Campbell and Thompson (2008) show that many predictive regressions beat the historical average return, once weak restrictions are imposed on the signs of coeffcients and return forecasts.

We contribute to this literature by providing evidence that an economically-motivated predictive variable that measures credit conditions has robust in-sample and out-of-sample predictive power in forecasting future stock and bond excess returns. Further, the predictive power is strongest in the post-1990 time period and is quantitatively significant.

The macroeconomic literature has a long tradition of studying how supply-based measures of credit could impact the overall economy. Some of this work was prompted by papers that have studied the impact of the Federal Reserve's monetary policy on stock and bond returns (Thorbecke (1997), Bernanke and Kuttner (2005), Patelis (1997) among others) as well as the behavior of business condition proxies such as term premia, default premia, and dividend yields (Jensen et al. (1996)).

A possible explanation of the predictive power of monetary indicators relates to the credit channel of monetary policy transmission (Bernanke and Gertler (1995)). In particular, a tighter monetary policy leads to a reduced and costlier bank loan supply that in turn impacts future asset returns. However, past work has not considered the direct influence of bank loan supply changes on asset returns. In particular, it is unclear whether the credit channel either through a monetary policy transmission mechanism or some other economic channel has predictive power for asset returns. In this paper, we address this issue and examine whether shocks to the aggregate bank loan supply aff ect stock and bond returns.

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Credit Conditions and Expected Stock and Bond Returns