Asset Class Return

Economic Forecasting

1. Econometrics: Better to forecast expansion than depression.

2. Economic Indicators:

3. Checklist approach: Subjective, need other models to compliment

Cash Instruments:

Short term debt<1 year of maturity.

Shift to lower credit instruments when expecting economy to improve

Shift to shorter term when expect interest rate to increase later

Credit risk free bonds

Look at inflation and interest rate.

Increase in short term interest rate will increase the medium and long term yield. But may reduce the yield if short term increased too much and can hurt the economy.

Credit Risky Bonds

Recession has higher yield because of difficult to get loans and higher default risk

Emerging Country bonds

Not issued in domestic currency and has to pay back in hard currency (e.g. USD, Euro). Easier to default.

Need Country risk analysis: economic and political situations

Inflation Index Bonds

Yield depends on demand and supply. Yield falls when inflation increases.

Common Stocks:

Depends on future cash flows (dividends and stock price) and discount rate.

Eventually depends on the GDP trend, thus is a function of labor participation rate, total productivity factor etc.

Competition is good for the whole stock market.

Cyclical stocks have high business risk and leverage risk.

Defensive stocks have low premium at recession

Early stage of recovery: Leaner corporate structure, idle facility can be used, less input costs, revenue growing; Also higher P/E ratio just like growth stock

Later in expansion: high inflation rate and also interest rate; Also lower P/E ratio

Low inflation will have high P/E as E is more real.

Emerging Market Stocks

Real Estate affected by interest rate, inflation and shape of yield curve.