Download Economic Analysis

Portfolio Management
Unit – III
Session No. 22
Topic: Economic Analysis
Session Plan
• Recap the previous session
• International Interactions
• Economic Forecasting
• Economic Information in Forecasting Asset Class Returns
• Summarizing and Q & A
Economic Analysis
• International Interactions
• The dependence of any particular country on international interactions is a
function of its relative size and its degree of specialization.
• Large countries with diverse economies, such as the United States, tend to be
less influenced by developments elsewhere than small countries, such as Chile,
whose production depends significantly on a few commodities like copper.
• Increasing globalization of trade, capital flows, and direct investment
means that practically all countries are increasingly affected by international
interactions.
Economic Analysis
• International Interactions - Elements
• Macroeconomic Linkages
• Countries’ economies are directly affected by changes in the foreign demand
for their exports.
• The other international linkages (other than trade) at work, such as those
resulting from cross-border direct business investment
• Interest/Exchange rate linkages
• One of the linkages of most concern to investors involves interest rates and
exchange rates. Sometimes, short-term interest rates are affected by
developments in other countries because one central bank pursues a formal or
informal exchange rate link with another currency.
• Emerging markets
• There are some special considerations in setting capital market expectations for
emerging countries.
Economic Analysis
• Economic Forecasting
• Practical basics of macroeconomics for the investment analyst with many realworld illustrations which indicate some of the disciplines that the analyst can
apply to economic forecasting.
• Often, analysts consider the implications of a variety of approaches, which
will often raise questions that lead to productive analysis and insight.
• Approaches:
• Econometric models, the most formal and mathematical approach to
economic forecasting.
• Leading indicators: variables that have been found to lead (precede) turns in
the economy.
• Checklists, requiring the subjective integration of the answers to a set of
relevant questions.
Economic Analysis
• Economic Forecasting Approaches:
1. Econometric Modeling
• Econometrics is the application of quantitative modeling and analysis grounded in
economic theory to the analysis of economic data.
• Whereas generic data analysis can involve variables of all descriptions (possibly
including economic, security characteristic, demographic, and statistical variables),
econometric analysis focuses on economic variables, using economic theory to model
their relationships.
• A very simple model is presented in the following series of equations:
• 1. GDP growth = function of (Consumer spending growth and Investment growth)
• 2. Consumer spending growth = function of (Consumer income growth lagged one
period and Interest rate*)
• 3. Investment growth = function of (GDP growth lagged one period and Interest
rate*)
• 4. Consumer income growth lagged one period = Consumer spending growth lagged
one period
Economic Analysis
• Economic Forecasting Approaches:
2. Economic Indicators
• Economic indicators are economic statistics provided by government and
established private organizations that contain information on an economy’s
recent past activity or its current or future position in the business cycle.
• Lagging economic indicators and coincident indicators are indicators of
recent past and current economic activity, respectively.
• A leading economic indicator (LEI) is a variable that varies with the
business cycle but at a fairly consistent time interval before a turn in the
business cycle.
Economic Analysis
• Economic Forecasting Approaches:
3. Checklist Approach
• Formally or informally, many forecasters consider a whole range of economic
data to assess the future position of the economy.
• Checklist assessments are straightforward but time-consuming because they
require looking at the widest possible range of data.
• The data may then be extrapolated into forecasts via objective statistical
methods, such as time-series analysis, or via more subjective or judgmental
means.
• An analyst may then assess whether the measures are in an equilibrium state or
nearer to an extreme reading.
Economic Analysis
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Economic Information in Forecasting Asset Class Returns
Cash and Equivalents
Nominal Default-Free Bonds
Defaultable Debt
Emerging Market Bonds
Inflation-Indexed Bonds
Common Shares
Real Estate
Currencies
Economic Analysis
• Economic Information in Forecasting Asset Class Returns
1. Cash and Equivalents
• Cash managers make money through selection of the maturity of the paper in
their portfolio or, if permitted by investment policy, by taking credit risk.
• Longer maturities and lower credit ratings reward the extra risk with
higher expected returns.
• Managers lengthen or shorten maturities according to their expectations of
where interest rates will go next.
• Normally, longer-maturity paper will pay a higher interest rate than shortermaturity paper.
Economic Analysis
2. Nominal Default-Free Bonds
• Nominal default-free bonds are conventional bonds that have no (or
minimal) default risk. Conventional government bonds of developed countries
are the best example. Thus, our focus is on the government yield curve.
3. Defaultable Debt
• Defaultable debt is debt with some meaningful amount of credit risk —in
particular, most corporate debt. For corporate debt, such as certificates of
deposit and bonds, the spread over Treasuries represents at least in part the
market’s perception of default risk.
Economic Analysis
4. Emerging Market Bonds
• Emerging market debt refers here to the sovereign debt (Govt issue for
Foreign Currency) of non-developed countries. So far, we have considered
only government issues and regarded them as virtually risk-free from a credit
point of view.
5. Inflation-Indexed Bonds
• Many governments now issue bonds linked to inflation, so in principle, we
can directly observe the market’s forecast of inflation by comparing the yield
of these indexed bonds with the yield on similarly dated conventional bonds.
Economic Analysis
6. Common Shares
• To relate economic analysis to common equity valuation, it is useful to think
of economic factors, first, in the way that they affect company earnings and,
second, in the way that they affect interest rates, bond yields, and liquidity.
7. Real Estate
• To identify growth in consumption, real interest rates, the term structure of
interest rates, and unexpected inflation as systematic determinants of real
estate returns.
• Interest rates are linked with a number of factors that affect the supply and
demand for real estate, such as construction financing costs and the costs of
mortgage financing.
Economic Analysis
8. Currencies
• The exchange rate between two countries reflects the balance of buyers
and sellers.
• One major reason for buying and selling foreign currencies is to facilitate
trade in goods and services (exports and imports).
• If a country begins to import more, the currency will tend to depreciate (all
else being equal).
• Hence, considerable attention is usually paid to determining a competitive
exchange rate at which the trade balance—or, more broadly, the current
account balance (which includes services and transfers)—is zero.