Robust Tests for Factor-Augmented Regressions with an Application to the novel EA-MD Dataset

Abstract: We present four novel tests of equal predictive accuracy and encompassing for out-of-sample forecasts based on factor-augmented regression. We extend the work of Pitarakis (2023a,b) to develop the inferential theory of predictive regressions with generated regressors which are estimated by using Common Correlated Effects (henceforth CCE) - a technique that utilizes cross-sectional averages of grouped series. It is particularly useful since large datasets of such structure are becoming increasingly popular. Under our framework, CCE-based tests are asymptotically normal and robust to overspecification of the number of factors, which is in stark contrast to existing methodologies in the CCE context. Our tests are highly applicable in practice as they accommodate for different predictor types (e.g., stationary and highly persistent factors), and remain invariant to the location of structural breaks in loadings. Extensive Monte Carlo simulations indicate that our tests exhibit excellent local power properties. Finally, we apply our tests to a novel EA-MD-QD dataset by Barigozzi et al. (2024b), which covers Euro Area as a whole and primary member countries. We demonstrate that CCE factors offer a substantial predictive power even under varying data persistence and structural breaks.