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The stock market reaction to macroeconomic forces: the case of financial and nonfinancial sectors Daniele Angelo Previati a, Franco Fiordelisi a,b, Giuseppe Galloppo c,d University of Roma Tre, Rome, Italy- [email protected], Via Silvio D'Amico 77, Rome. bMiddlesex Business School, U.K. [email protected], c Deim Department of Economics and Business, University of Tuscia, Viterbo, Italy [email protected], Via del a Paradiso 47, 01100, Viterbo , d Ceis Foundation, University of Rome Tor Vergata, Italy – [email protected]; Via Columbia 2, 00133, Rome. Abstract This paper analyzes the impact of macroeconomic data on G7 stock market area. It is widely believed that the stock market is sensitive to macroeconomic news. There is a widespread belief that the stock market is sensitive to announcements of economic events. Indeed market participants tend to follow closely government releases of economic data. This paper employs Stock market Indexes, to systematically examine stock market reactions, comparing financial and non financial sectors, to a broad list of nominal and real macroeconomic variables. The monthly and quarterly data used in this paper cover the period January 1990 to December 2015. The relation between returns, fundamentals and macroeconomic conditions is of central importance to financial decision making. Investors need to know how returns and fundamentals are affected by changes in macroeconomic conditions for portfolio allocation, risk management and asset pricing purposes. While previous paper focused just on a very small set of variables or on monetary policy action and mainly focusing on the short term effect of macroeconomic data announcements, there exists a large gap in the empirical identification of the state variables determining asset pricing. Indeed, despite the strong association as suggested by the press between movements in stock prices and macroeconomic announcements, there has been relatively scanty hard evidence to support the belief that stock prices respond to general macroeconomic data apart from some types of monetary information. By considering various ways to distinguish between different conditions of the economy, the use of Johansen-Juselius (1990) Multivariate Cointegration and Vector Error Correction Model technique, indicate that there are both long and short run linkages between macroeconomic variable and stock index in each local market. Several variables concerning real economic activity that have received little attention in previous research are shown to have a significant impact on stock prices. Using firm-level data, the paper also presents evidence for the different reaction to macroeconomic data according to firm ‘characteristics. In this context the results show that the response of stock returns to macroeconomic data depends on individual leverage characteristics of firms. Specifically, stocks of companies that are likely to be credit constrained react more strongly than stocks of relatively unconstrained firms. Lastly reactions of stocks to macroeconomic data also change over the business cycle. Under this perspective little is known about the response of stock returns to unexpected changes in macroeconomic conditions. This paper aims to fill this void by analyzing the reactions of stock returns to a wide range of macroeconomic variables. To be specific this paper contributes to the understanding of financial market reactions to macroeconomic data in three ways. First, we extend previous research by examining more macroeconomic data to help identify a more rigorous approach for financial markets’ reaction. Second, Differently to most of previous literature we focus on a medium and long term market reaction so as to be more in line with the allocation decisions of large investment funds. Third, this paper provides the first evidence for the different reactions to macroeconomic news by discriminating among different fundamental ‘firm conditions. Moreover understanding the relationship between macroeconomic variables and stock markets can help investors to diversify their portfolio and choose a country for investment to improve their risk- return trade off. There are fewer studies which look at the potential benefits of knowing this relationship, especially in making a portfolio when we have macroeconomic shock which could influence investors ‘risk attitude and force them to suspend or delay their investments. This paper aims to enhance the investor understanding and evaluation in terms of sensitivity of the respective stock market index to the systematic impact of a wide set of macroeconomic factors (we consider, just to name a few: inflation rate, GDP growth rate, industrial production, sentiment indicator and employment rate). This also contributes to a better understanding of international diversification reducing risk when comparing national economies for choosing a country to put in portfolio. Key words: Macro-economic data, VECM models, Stock market reaction, Business cycle, G7 area. JEL code: G14, G15, G18