Consumption, (Dis)Aggregate Wealth and Asset Returns

In this work, I analyze the importance of the disaggregation of asset wealth into its main components (financial and housing wealth). I show, from the consumer's intertemporal budget constraint, that the residuals of the trend relationship among consumption, financial wealth, housing wealth and labor income (summarized by the variable cday) should help to predict quarterly asset returns, and to provide better forecasts than a variable like cay from Lettau and Ludvigson (2001), which considers aggregate wealth instead. Using data for the United Kingdom, I show that the superior forecasting power of cday is due to: (i) its ability to track the changes in the composition of asset wealth and the specificities of the different assets; and (ii) the faster rate of convergence of the coefficients to the "long-run equilibrium" parameters. Unlike Lettau and Ludvigson (2001, 2004), the results suggest that, while financial wealth shocks are mainly transitory, fluctuations in housing wealth are very important due to their persistence. Governments and central banks should, therefore, pay special attention to the behavior of housing markets (and to a smaller extent to the behavior of financial markets) when defining macroeconomic stabilizing policies