Question

Your task involves an analysis of general economic conditions or systematic risk, i.e., the risk that affects all industries and companies, in the U.S. macroeconomy. Your goal is to determine in percentage terms an optimal allocation of $1,000,000 among the following three asset classes: U.S. equities, U.S. Treasury bonds, and cash.

The goal is to maximize your expected return over the next 12 months.

Write a 1- to 2-page paper providing your analysis of the asset classes' prospects and your justification of your allocation of monies among them.

Answer 1

Economic conditions refer to the present state of the economy in a country or region. The conditions change over time along with the economic and business cycles, as an economy goes through expansion and contraction. Economic conditions are considered to be sound or positive when an economy is expanding and are seen as adverse or negative when an economy is contracting.

A country's economic conditions are influenced by numerous macroeconomic and microeconomic factors, including monetary and fiscal policy, the state of the global economy, unemployment levels, productivity, exchange rates, inflation and many others.

Economic data is released on a regular basis, generally weekly or monthly and sometimes quarterly. Some economic indicators like the unemployment rate and GDP growth rate are monitored closely by market participants, as they help to make an assessment of economic conditions and potential changes in them. A plethora of economic indicators can be used to define the state of the economy or economic conditions, including the unemployment rate, levels of current account and budget surpluses or deficits, GDP growth rates and inflation rates.

Generally speaking, economic indicators can be categorized as leading, coincident or lagging. That is, they describe likely future economic conditions, current economic conditions or conditions of the recent past. Economists are typically most interested in leading indicators as a way to understand what economic conditions will be like in the next three to six months. For example, indicators like new orders for manufactured goods and new housing permits indicate the pace of future economic activity as it relates to the rate of manufacturing output and housing construction.

Other indicators that can forecast future economic conditions include consumer confidence index, new factory orders (the new orders for goods by retail and other businesses) and business inventories (the inventories maintained by businesses to keep up with demand).

Why Economic Conditions Matter for Investors and Businesses

Indicators of economic conditions provide important insights to investors and businesses. Investors use indicators of economic conditions to adjust their views on economic growth and profitability. An improvement in economic conditions would lead investors to be more optimistic about the future and potentially invest more as they expect positive returns. The opposite could be true if economic conditions worsen. Similarly, businesses monitor economic conditions to gain insight into their own sales growth and profitability. A fairly typical way of forecasting growth would be to use the previous year's trend as a baseline and augment it with the latest economic data and projections that are most relevant to their products and services. For example, a construction company would look at economic conditions in the housing sector to understand whether momentum is improving or slowing and adjust its business strategy accordingly.

Analysis of current economic situation of US :

Economic outlook:  After a modest slowdown in the third quarter, the economy appears to be maintaining a robust—even if likely slightly softening—growth momentum in the fourth quarter, buttressed primarily by upbeat private spending thanks to the winter holiday season. Indeed, consumer confidence remained elevated in November, while retail sales data in the same month signaled private consumption growth will accelerate somewhat in Q4 compared to the previous quarter. This should further be supported by steady job gains in the labor market, fanning upward wage pressures. However, a subdued housing sector should continue to weigh on the economy. On the trade front, the meeting between Donald Trump and Xi Jinping in early December yielded a 90-day truce. This ensured no new tariffs will be enacted during the period, which should limit disruptions in business activity for the time being. Indeed, despite concerns about tariffs, the manufacturing sector gained steam in November thanks to solid domestic demand. Nevertheless, the reprieve could be short-lived; the U.S. is set to increase the rate on existing tariffs from 10% to 25% on 2 March, in the likely event that trade talks fail to produce a substantive agreement.

Economic growth: Higher government spending and robust private consumption amid a tight labor market should underpin growth next year. However, the economy is poised to slow due to multiple headwinds, most crucially on rising interest rates, a global growth deceleration, and fading stimulus from the 2017 tax cuts. The main downside risk remains a further escalation of the trade war with China, which could disrupt business activity and weigh on business confidence and investment. FocusEconomics panelists see GDP expanding 2.5% in 2019, which is unchanged from last month’s estimate, and 1.7% in 2020.

Economic Data:

	2013	2014	2015	2016 2017
Population (million)	317	319	321	324	326
GDP per capita (USD)	52,737	54,657	56,411	57,559	59,501
GDP (USD bn)	16,692	17,428	18,121	18,624	19,391
Economic Growth (GDP, annual variation in %)	1.7	2.6	2.9	1.5	2.3
Domestic Demand (annual variation in %)	1.3	2.7	3.5	1.7	2.4
Consumption (annual variation in %)	1.5	2.9	3.6	2.7	2.8
Investment (annual variation in %)	5.0	6.2	3.9	0.7	4.0
Exports (G&S, annual variation in %)	3.5	4.3	0.4	-0.3	3.4
Imports (G&S, annual variation in %)	1.1	4.5	5.0	1.3	4.0
Industrial Production (annual variation in %)	2.0	3.1	-1.0	-1.9	1.6
Retail Sales (annual variation in %)	3.6	4.3	2.6	3.1	4.3
Unemployment Rate	7.4	6.2	5.3	4.9	4.4
Fiscal Balance (% of GDP)	-4.1	-2.8	-2.4	-3.1	-3.4
Public Debt (% of GDP)	104	104	105	107	106
Money (annual variation in %)	6.7	6.2	5.8	6.8	5.6
Inflation Rate (CPI, annual variation in %, eop)	1.5	0.7	0.7	2.1	2.1
Inflation Rate (CPI, annual variation in %)	1.5	1.6	0.1	1.3	2.1
Inflation (PPI, annual variation in %)	1.4	1.6	-0.9	0.4	2.3
Policy Interest Rate (%)	0.25	0.25	0.50	0.75	1.50
Stock Market (annual variation in %)	26.5	7.5	-2.2	13.4	25.1
Current Account (% of GDP)	-2.1	-2.1	-2.4	-2.4	-2.4
Current Account Balance (USD bn)	-349.5	-373.8	-434.6	-451.7	-466.3
Trade Balance (USD billion)	-700.5	-749.9	-761.9	-751.1	-807.5

Classes of Assets:

There’s some argument about exactly how many different classes of assets there are – three, four, five, or more – but many market analysts and financial advisors divide assets into the following five categories:

• Stocks or equities – Equities are shares of ownership that are issued by publicly-traded companies and traded on stock exchanges, such as the NYSE or Nasdaq. You can potentially profit from equities either through a rise in the share price or by receiving dividends. The asset class of equities is often subdivided by market capitalization into small cap, mid cap, and large cap stocks.
• Bonds or other fixed income investments – Fixed-income investments are investments in debt securities that pay a fixed rate of return in the form of interest. While not all fixed income investments offer a specific guaranteed return, such investments are generally considered to be less risky than investing in equities or other asset classes.
• Cash or cash equivalents, such as money market funds – The primary advantage of cash or cash equivalent investments is their liquidity. Money held in the form of cash or cash equivalents can be quickly and easily accessed at any time.
• Real estate or other tangible assets – Real estate and other physical assets are considered as an asset class that offers protection against inflation. The tangible nature of such assets also leads to them being considered as more of a “real” asset, as compared to assets that exist only in the form of financial instruments.
• Futures and other financial derivatives – This category includes futures contracts, the forex market, options, and an expanding array of financial derivatives, i.e., financial instruments that are based on, or derived from, an underlying asset. For example, stock options are a derivative of the underlying stocks

Financial advisors focus on asset class as a way to help investors diversify their portfolio. Different asset classes have different cash flows streams and varying degrees of risk. Investing in several different asset classes ensures a certain amount of diversity in investment selections. Diversification reduces risk and increases your probability of making a return.

Asset Class and Investing Strategy

Investors looking for alpha employ investment strategies focused on achieving alpha returns. Investment strategies can be tied to growth, value, income or a variety of other factors that help to identify and categorize investment options according to a specific set of criteria. Some analysts link criteria to performance and/or valuation metrics such as earnings-per-share growth (EPS) or the price-to-earnings (P/E) ratio. Other analysts are less concerned with performance and more concerned with the asset type or class. An investment in a particular asset class is an investment in an asset that exhibits a certain set of characteristics. As a result, investments in the same asset class tend to have similar cash flows.

Observation: Investment of about 45% should be made in equities and 25% in cash . That is a total of 70% investments will be in liquid form and quoted. Remaining 30% should be invested in Treasury Bills (Government securities). Although investment in Treasury Bills is safe but they have a lock in period and therefore cannot be encashed immediately.