Long-Run Inflation and Exchange Rates Hedge of Stocks in Brazil and Mexico

A substantial body of evidence documents the relationship between macroeconomic variables and stock returns and risk from developed countries. The evidence for emerging markets is limited, particularly identifying risk premia compensations for inflation and exchange rates. This paper attempts to quantify the short and long term relationship between inflation and exchange rates with over all stock market performance for the case of the two largest Latin American capital markets, Mexico and Brazil. Extending the Fisher model, the aim is to determine whether or not these markets have failed to keep pace with movements in those two variables (the most unstable and economic growth hampering variables in these economies during the last three decades), and therefore to what extent the stock market succeeds or fails to test as inflation hedges. The empirical evidence is presented assuming positioning of a local investor in their own market, and from the point of view of a U.S. investor in each of these markets. Two unit root tests are also presented to stress long term relationships between stock returns, inflation, and foreign exchange.