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

•We develop an alternative econometric structure for financial investor decision making•The structural equation model (SEM), quantifies a new index - the European Latent Factor•It determines how the changing macro and political environment impact stocks and bonds•The Latent Factor can act as a proxy for investor risk appetite

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.