Abstract
This study investigates how exchange rate pass-through (ERPT) affects sectoral stock market returns in South Africa, an emerging market characterized by a large stock exchange and volatile currency, and the USA, a developed country with a high level of stock market liquidity and stable exchange rates compared to emerging markets. ERPT might affect sectoral returns via the cost or demand channel. Through the cost channel, a change in the exchange rate might affect the prices of imported goods and services, which further alters the production costs for companies. This consequently leads to a change in profits and stock market returns. Through the demand channel, volatility in the exchange rate changes import and domestic prices, both for foreign and domestic customers, which might change demand for companies’ goods and services. The change in demand affects the company revenues and earnings, which might further spillover to equity market prices. On the account these two ways in which ERPT might affect stock market prices, the study utilized ERPT to import prices and ERPT to CPI, which reflects domestic prices. The steps involved in the empirical analysis included using a rolling-window ordinary least squares approach to extract time series of ERPT coefficients, followed by bivariate wavelet coherence analysis to examine the evolving co-movement between sectoral returns and ERPT over time. This step involves assessing this co-movement in the time-frequency domain based on the wavelet coherence methodology. Finally, the International Capital Asset Pricing model was used to assess the pricing of ERPT on sectoral stock market returns across different investment horizons. Monthly data was used in the study, and the number of sectors analyzed for the S&P 500 and JSE were 6 and 7, respectively. Findings reveal that ERPT in South Africa and the USA fluctuates considerably but generally weakened from 1995 to 2025. Import-price ERPT consistently exceeds CPI ERPT in both countries, mirroring existing literature. The co-movement between ERPT and sectoral returns is highly time-varying, intensifying during crisis periods, such as 1999, 2008, and 2020. Moreover, ERPT exhibits stronger interdependence with returns at longer cycles, whereas shorter cycles display minimal linkage. Using an ICAPM framework, this study found that ERPT does not influence excess share returns in the short run, but over the long run, equity returns are priced in ERPT. Depending on the sector, ERPT necessitated a risk premium or risk discount. By analyzing how ERPT, currency-driven inflation, affects stock market returns, this study highlights a novel mechanism by which fluctuations in prices induced by exchange rate fluctuations affect the equity market. The findings are important for investors in identifying which sectors in the market can benefit or be hurt by exchange rate-induced inflation.