Consumer spending is usually gauged through the use of store sales data, retail sales, and consumer consumption data. The primary driver of consumer spending is consumer after-tax income, which in the United States is gauged using non-farm payroll data and new unemployment claims.

Saving rates are influenced by consumer confidence and changes in the investment environment. Specifically, consumer confidence increases as the economy starts to recover from a recession, and consumers begin to spend more. At the same time, stock prices start to rise and momentum begins to build. Consumers continue spending until the economy shows definite signs that it has peaked (i.e., top of the business cycle) and reversed. At this point, consumers begin saving more and more until the economy “turns the corner,” and the cycle starts over.

The permanent income hypothesis asserts that consumer spending is mostly driven by long-run income expectations, not cyclical swings in wealth. If income temporarily declines, consumers continue to spend (from savings) as longterm income expectations are more stable.

The average growth rate over the economic cycle is limited by the longterm trend growth rate. A basic model for forecasting trend economic growth focuses on the following:

– Growth in labor input based on growth in the labor force and labor participation.
– Growth in capital.
– Growth in total factor productivity.

The wealth effect suggests consumers spend more when wealth increases and less when it decreases. The wealth effect would contribute to swings between higher and lower spending and would amplify swings in the business cycle.

Unanticipated events that occur outside the normal course of an economy are referred to as exogenous shocks. Since the events are unanticipated, they are not already built into current market prices, whereas normal trends in an economy, which would be considered endogenous, are built into market prices.

These nonfinancial assets and liabilities are referred to as extended portfolio assets and liabilities because they are not included in traditional balance sheets. The traditional accounting balance sheet encompasses an organization’s assets, liabilities, and owner’s equity.

An economic balance sheet contains all of an organization’s financial assets and liabilities, as well as any nonfinancial assets and liabilities that are applicable to the asset allocation decision. Human capital is most likely to be a part of the extended portfolio assets. The others (financial asset and financial liabilities) are already part of a more traditional balance sheet.

Goals-based approaches are geared toward asset allocations for subportfolios, which help individuals or families achieve lifestyle and aspirational financial objectives. Each sub-portfolio will have a unique asset allocation designed to meet the stated goals.

Risk concepts associated with liability-relative approaches focus on not having enough assets to pay liabilities when they come due. The differences between asset and liability characteristics (e.g., size, sensitivity to interest rate changes) are the main drivers of risk for liability-relative asset allocation approaches.

Calendar rebalancing is the rebalancing of a portfolio to its strategic allocation on a predetermined, regular basis. The primary benefit of calendar rebalancing is that it provides discipline without the requirement for constant monitoring. The drawback is that the portfolio could stray considerably between rebalancing dates and return to its strategic allocation ranges on the rebalancing date.

Tactical asset allocation (TAA) is an active management strategy that deviates from the strategic asset allocation (SAA) to take advantage of perceived short-term opportunities in the market. TAA introduces additional risk, seeking incremental return, often called alpha.

Examples of risk factors include volatility, liquidity, inflation, interest rates, duration, foreign exchange, and default risk. Risk factor exposures may overlap across multiple asset classes. Examining these overlapping risk factors can help investors identify the correlations among asset classes.

The financial equilibrium approach assumes that supply and demand in global asset markets are in balance. Financial models such as the International Capital Asset Pricing Model (ICAPM) will value securities correctly.

A negative interest rate is defined as a net payment made to keep money on deposit at a financial institution or payment of a net fee to invest in short-term instruments. With negative interest rates, banks charge you interest to keep cash with them, rather than paying you interest. The negative interest rate is meant to be an incentive for banks to make loans during a period in which they would rather hang on to funds.

Cash managers adjust the maturity and creditworthiness of their cash investments depending on their forecasts for interest rates and the economy. Longer maturity and less creditworthy instruments have higher expected return but also more risk.

The interest rate for overnight loans among U.S. banks is the Federal Funds rate and is set by the Federal Reserve. The Federal Reserve sets the Federal Funds rate through its purchases and sales of government debt.

The most common type of credit risk-free bonds are those issued by governments in developed countries. In practice, government bonds of financially stable countries are treated as risk-free bonds, as governments can raise taxes or indeed print money to repay their domestic currency debt. The yield on these bonds is composed of a real yield and the expected inflation over the investment horizon.

The most common type of credit risky bonds are corporate bonds. Most corporate bonds are debentures, meaning they are not secured by collateral. Corporate bonds offer a higher yield than some other fixed-income investments, but for a price in terms of added risk.

Several governments issue bonds that adjust for inflation so that the investor is protected against it. The yield on these bonds has been correlated with three economic factors:

– Their yield rises as the real economy expands (contracts). This is primarily because their yield is tracking short-term interest rates, which also move with the economy.
– Their yield Falls as inflation accelerates and more investors seek to buy the inflation-index bonds. The increase in demand leads to higher prices and lower yields.
– Their yield Changes with supply and demand. These markets are somewhat small, making supply and demand changes more important.

Investors should answer the following questions before investing in unstable political and social systems and heavy infrastructure investments financed by foreign borrowing:

– Does the country have responsible fiscal and monetary policies? This is determined by examining the deficit to GDP ratio.
– What is the expected growth? It should be at least 4%.
– Does the country have reasonable currency values and current account deficits? A volatile currency discourages needed foreign investment, and an overvalued currency encourages excessive government borrowing.
– Is the country too highly levered? Too much debt can lead to a financial crisis if foreign capital flees the country.
– What is the level of foreign exchange reserves relative to short-term debt? Many emerging country loans must be paid back in a foreign currency.
– What is the government’s stance regarding structural reform? A supportive government makes the investment environment more hospitable.

The effect of a government’s promotion of competition in the marketplace is the increase in the efficiency of the economy, likely leading to higher long-term growth in the economy and the stock market.

The idea that diversification is achieved by ensuring that each asset class contributes the same amount to the total portfolio risk is associated with the risk parity asset allocation approach. The criticism of this approach is that it ignores expected returns and focuses only on risk.

Rebalancing is the act of adjusting portfolio asset weights in order to restore target allocations or risk levels over time. Investment managers rebalance portfolios for a number of reasons, including in response to changing client goals and capital market expectations or changes in tactical allocations.

Portfolio rebalancing safeguards the investor from being overly exposed to undesirable risks. The key factors that impact the optimal corridor width (or the rebalancing range) of an asset class include the following:

– Transaction costs.
– Risk tolerance.
– Correlations with the rest of the portfolio.
– The volatility of the rest of the portfolio.

There are several strategies for rebalancing. Percentage range rebalancing involves setting trigger points around the optimal percentage allocation and rebalancing back to the target allocation or partially correcting when those trigger points are hit.

A carry trade is just another form of leverage that has the potential to be highly profitable over the long term if correctly managed. Return is enhanced by borrowing at a lower rate to invest the funds in an asset that will generate a higher rate of return. The following ways are used to implement a carry trade:

– Borrowing at lower shorter-term rates to invest at higher longer-term rates.
– Borrowing in a lower interest rate and investing in a higher interest rate currency.

High-yield bonds are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. Speculative-grade bonds also known as junk bonds are high-yielding high-risk security, typically issued by a company seeking to raise capital quickly in order to finance a takeover. They are securities deemed to not be of investment quality by a credit rating agency.

Credit risk, or default risk, is the risk that a financial loss will be incurred if a counterparty to a transaction does not fulfill its financial obligations in a timely manner. Credit risk is made up of two components. They are default risk and loss severity (or loss given default).

Spread risk refers to a decline in price relative to credit risk free bonds due to spread widening. Spread risk refers to the danger that the interest rate on a loan or bond turns out to be too low relative to an investment with a lower default risk for it to be a good use of funds.