Inflation, Financial Uncertainty, and Capital Markets: A Comparative Case of US, UK, and China

How do inflation and financial uncertainty impact capital markets over time? In this paper, we analyze the stock index from three major capital markets (US S&P 500, UK FTSE100, and China SSE) to find their time-varying co-integration magnitude with inflation and financial uncertainty, while controlling for other macroeconomic variables including oil price, gold price, and foreign exchange rate. We further advance to include sectoral analysis in the US market and study 11 sub-groups of S&P500 to find the largest inflation-affected industries. The CBOE volatility indices' relationship with inflation and financial uncertainty are also examined using ARFIMA models. The VAR-Granger analysis is used to find the causality direction among the market indices and the inflation levels. Our findings illustrate statistically significant and positive co-integration among all three indices and their respective inflation levels. On the sector level, our paper suggests higher co-integration among inflation and value sectors rather than the growth sectors. We have also conducted an interrupted time series analysis to determine the 2010 post-financial crisis Feds regulation on the hedging capability of the financial sector. Our study confirms financial uncertainty to be a statistically significant and positive driver of US market volatility (VIX) and relevant ETFs. Granger causality tests show bidirectional causality between inflation and index level in the US and UK, whereas in China we are experiencing a unidirectional causality from the capital market to the inflation levels.