This note provides a brief overview of the relationship between the macro behaviour of the economy and the resulting impact on investment returns. It is designed to be used within a course on investments or portfolio management. The note starts by establishing a framework for estimating the long-run expected returns of the two major categories of financial assets - equities and (long-term) bonds - on the basis of the fundamental valuation theorem, which states that value comes from expected future discounted cash flows. The note demonstrates that this theorem implies that the long-run expected real returns on equities depend on the dividend growth rate and the expected average growth rate in dividends, which in turn depends on long-run macroeconomic growth. Expected long-term real returns on bonds depend on the yield to maturity and the long-run inflation rate. The note then goes on to establish the long-run behaviour of four key macroeconomic variables: output, inflation, interest rates, and exchange rates. An overview of how to identify business cycle positions is an important component of this analysis. Also, the analysis focuses on methods for identifying disequilibrium situations for interest rates. Finally, the note concludes by discussing some short-run influences on macroeconomic variables and the key role of monetary policy.
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