Using economic information in forecasting asset returns

Using economic information in forecasting asset returns

Cash and Equivalents

1. Longer maturities and lower credit ratings reward the extra risk with higher expected returns
2. Managers lengthen or shorten maturities according to their expectations of where interest will go next
3. Normally longer maturity papers will pay a higher interest rate than shorter maturity papers even if overnight interest rates are expected to remain the same, because the risk of loss if greater for the longer term paper
4. If he thinks the economy is going to improve, so that less creditworthy instruments have less chance of default, he will shift more assets into lower rated cash instruments.

Nominal Default Free Bonds

1. Yield is composed of a real yield and the expected inflation over the investment horizon
2. The investor with a short term time horizon will focus on cyclical changes in the economy and changes in short term interest rates
3. Higher expected economic growth results in higher yields because of anticipated greater demand for loan able funds and possible higher inflation
4. An increase in short term interest rates increases medium and long term interest rates, but medium and long term interest rates may also fall if the interest rate increase is considerable to sufficiently slow down the economy

Credit Risky Bonds

1. Corporate Bonds
2. Risk Premium = Yield on corporate debt – Yield on treasuries with similar maturity
3. During recession the credit risk premium increases because default is more likely

Emerging Market Government Bonds

1. Most emerging market debt is denominated in non domestic currency
2. Default risk for foreign currency denominated bonds is higher

Inflation Indexed Bonds

1. TIPS
2. These bonds are both credit risk and inflation risk free
3. If inflation start rising, the yield on these bonds will fall, as demand for these bonds increases

Common Stock

1. Value of an asset is PV of future cash flows
2. Earnings and risk adjusted required return are important
3. Short term growth is affected by the business cycle
4. In a recession, sales and earnings decrease. Non cyclical or defensive stocks are less affected by the business cycle and will have lower risk premiums and higher valuations than cyclical stocks
5. Cyclical stocks are characterized by high business risk and / or high fixed costs
6. In early expansion phase, stocks are rising because sales are increasing and input cost are fairly stable.
7. Later on in the expansion input costs start to increase and earnings growth slow, interest rates also increase during late expansion which is a further negative for stock valuation
8. P/E ratios are high in an early expansion period when interest rates are low and earnings prospects are high. They decline as earning prospects decline. For cyclical stocks P/E ratios may be quite high in a recession.

Emerging Market Stocks

1. Historical returns for emerging markets stocks are higher and more variable than those in the developed world and seem to be positively correlated with business cycles in the developed world.
2. The correlation is due to trade flows and capital flows

Real Estate

1. Real estate assets are affected by interest rates, inflation and the shape of the yield curve and consumption.
2. Interest rates affect both the supply of and demand for properties through mortgage financing rates.
3. They also determine the capitalization rate used to value cash flows