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RFGI = 1.4 × FS,FGI − 0.2 × FB,FGI + εFGIThe variance of the stock and bond factors are 0.04 and 0.007 respectively. The covariance of the two factors is 0.01. Litner and Cabell will use these results to forecast the covariance of the returns of FGI and VCC. Litner and Cabell intend to augment their capital market expectations models with data on consumer and business spending. They have not used this data before, but they feel this data can help in the prediction of changes in the business cycle. In order to have more focus, they want to determine which of the two measures might be more important. They think it would be better to focus on business spending for several reasons. Litner says that business spending is more volatile than consumer spending. Cabell says that business spending is also the larger of the two. Inflation is another variable that Litner and Cabell consider for their models. They discuss the relationship between inflation and asset returns. Cabell suggests that inflation can be used with GDP growth for predicting the Fed’s next move on interest rates. They look at their macroeconomic data to see how the current GDP growth compares to the trend GDP growth and the current inflation compares to the Fed’s announced inflation target. They find that the current GDP growth is higher than the trend GDP growth. Inflation is lower than the announced target from the central bank. Litner and Cabell employ the Taylor Rule for predicting a change, if any, in the central bank’s target for the short-term interest rate. In considering how to address interest rates in their newsletter, Litner and Cabell also look at the shape of the yield curve, which is currently flat. Litner and Cabell discuss the conditions that could give a flat yield curve. Litner says that such a curve is indicative of restrictive monetary policy. Cabell says that a flat yield curve is indicative of expansionary fiscal policy. Litner and Cabell discuss the use of economic indicators that are available for governments and international organizations, and they agree that the availability of the indicators is one of the advantages of using such indicators. Litner says another advantage of such indicators is that economic variables and asset returns tend to have fairly stable relationships with the indicators that are fairly consistent over time. Cabell adds that another advantage is that the economic indicators can be readily adapted for specific purposes. Having assessed their available resources and strategy, Litner and Cabell begin composing their newsletter for TTI employees. In composing their model using the macroeconomic data, the approach of Litner and Cabell:
RVCC = 0.8 × FS,VCC + 0.1 × FB,VCC + εVCC
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