Aggregate Wealth and Consumption, and the Term Structure of Interest Rates

The equilibrium value of the market portfolio of all assets, i.e. aggregate wealth is calculated within a continuous-time Rubinstein/Lucas model. Aggregate wealth is a function of aggregate consumption and the state of the economy. The exante expected rate of return of the market portfolio varies with economic conditions, and these conditions are revealed by the equilibrium term structure of nominal bond yields and partially revealed by the aggregate consumption-to-wealth ratio cay. Using simulations of quarterly observations, linear regressions of expost excess market returns on predictive variables are studied. The ratio cay in isolation has modest predictive power for excess returns. Similarly, the level and slope of the term structure have modest power as predictors. However, the relation between expected excess return and the underlying state variables is nonlinear and cay picks up this structure. For this reason a multiple regression that includes both cay and the term structure variables captures the nonlinearity and it has considerable predictive power.