Download Investments: An Introduction Sixth Edition

Chapter 9
The Macroeconomic
Environment for Investment
Decisions
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LEARNING OBJECTIVES
1. Define gross domestic product and specify its
components.
2. Identify the factors that affect a specific rate of
interest.
3. Differentiate the discount rate, the federal funds
rate, and the target federal funds rate.
4. Describe the tools of monetary policy and the
mechanics of open market operations.
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LEARNING OBJECTIVES
5. Contrast the different measures of the money
supply.
6. Explain how monetary and fiscal policy and a
federal government deficit may affect securities
prices.
7. Determine which investments may be desirable
in an inflationary environment.
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Introduction
-Investment decisions are affected by the various
events occurring in the economic environment.
-These events like unexpected changes in interest
rates & recession cause the securities market to
react.
-The securities market reaction varies and cannot
be expected.
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The Economic Environment
-The economic environment suggests that the
economy does not follow regularly predictable
patterns but have periods of expansion and
contraction upon which all investment decisions
are made.
-These periods vary in length & severity that the
circumstances affecting economy in one period
may not affect it in subsequent periods.
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Economic Environment Vs. Business Cycle
-The economic environment was mistakenly
referred to as “business cycle”.
-However, economic environment and business
cycle should not be interchangeably used.
-As opposed to economic environment, the word
“cycle” implies a regularly repeated pattern of
events, such as the seasons of the year.
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The Business Cycle
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The Economic Environment
Historical background
• 1972 - 1999: only four periods of
recession (started with Arab states of
oil exports embargo as of Yom Kippur
War in 1973- called first oil shock as
price increased from $3 per barrel to
nearly $12)
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The Economic Environment
Historical background
-The energy crisis in 1979 upon the
Iranian revolution and the resulted
decline in the production of oil by 4%
forcing prices to go up.
-In 1980, production of oil in Iran stopped.
After 1980, oil prices began a decline as
production in Iran/Iraq returned to normal.
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The Economic Environment
• 1991 - 2001: ten years of unbroken
economic growth.
• Second quarter of 2002: economy
sustained negative growth.
- In July 2008, the price reached $147 a
barrel. That large increase was a
contributing factor to the economic
downturn.
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Recession
• Recession (or contraction) A period of
rising unemployment and declining national
output.
– Depression a particularly severe recession
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Inflation
• During most economic expansions
–tendency for prices to increase
(inflation)
• The late 1990’s have been an
exception to this pattern
– modest inflation
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The Economic Environment
• During the 1930s, the failures of many
commercial banks had an enormous impact
on the economy and contributed to the
Great Depression.
During the late 1980s, the failure of many
savings and loan associations and
commercial banks created a financial crisis.
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Economic Environment effect on stock prices
• In many cases there is a strong relationship between stock
prices and the aggregate economy.
• The dramatic increase in the price of oil, the collapse of
segments of the banking and financial system, and the severe
decline in stock prices did inflict losses on investors during
2007 through 2009.
• The next economic crisis may be very different.
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Measures of Economic Activity
• Economic activity is measured by aggregate indicators
such as the level of production & national output.
• Gross domestic product (GDP)
-the most common measure of economic activity.
-total dollar value of all final goods & services newly
produced within a country’s boundaries by domestic
factors of production.
-Example: Cars made in the U.S. by Toyota are
included in GDP, while IBM computers produced in
Europe or Asia are not.
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• GDP is the summation of expenditures:
– GDP = C + I + G + E
• Expenditures are:
(C): Personal consumption
(I): Gross private domestic investment like
investment in property &equipment
(G):Government spending
(E): Net exports (E)
• Government taxation reduces the ability of
individuals and firms to spend ,but it forces them
to contribute to the nation’s GDP by tax revenues
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GNP Vs GDP
• (GNP) was replaced by GDP to emphasizes the
country’s output of goods & services within its
geographical boundaries.
• GNP is the total value of all final goods and
services newly produced by an economy
including income generated abroad by U.S. firms
& excluding income earned in the U.S. by foreign
firms.
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Measures of Consumer Confidence
• Consumer confidence affects spending, which has an
impact on corporate profits and levels of
employment.
• Measures of consumer confidence :
-The Consumer Confidence Index (CCI)
-The Consumer Sentiment Index (CSI)
• Both measures provide indicators of consumer
attitudes by focusing on
(1) consumer perceptions of business conditions
(2) consumer perceptions of their financial condition
(3) consumer willingness to purchase durables
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Forecasting Changes in the Economy
• Changes in the indexes suggest changes in
consumer optimism or pessimism
• A decline in consumer confidence forecasts a
reduction in the level of economic activity &vice
versa.
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• From an investor’s perspective, the change in the
economy resulting from a change in consumer
confidence could lead to a shift in the individual’s
portfolio.
• A reduction in confidence that leads to economic
contraction argues for movement out of growth
companies into defensive stocks such as utilities
or large firms (IBM or Merck) and debt
instruments.
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Leading Indicators
• Leading indicators: the usefulness of the index of
leading indicators for trading in stocks is limited,
because stock prices are one of the leading
indicators.
• One indicator by itself is not an accurate
forecaster.
• It is impossible to tell when an indicator has
changed.
• The inability to forecast changes in stock prices is
consistent with the efficient market hypothesis.
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Forecasting Changes in the Economy
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Measures of Inflation
• Inflation is a general rise in prices and an
important source of risk.
• Inflation is measured by two indexes:
• Consumer price index (CPI):measures the cost of
a basket of goods and services over time.
• The Consumer Price Index is separated into two
indices:
• -The all encompassing CPI
-The “core” CPI which omits food and energy,
whose prices tend to be more volatile.
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• An alternative measure of inflation to the CPI is
the index of Personal Consumption Expenditures
(PCE)
• The PCE measures expenditures and the impact
of changes in prices on consumer behavior.
• Producer price index (PPI): measures the
wholesale cost of goods over a period of time.
• Changes in the Producer Price Index often
forecast changes in the Consumer Price Index.
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• The rate of inflation is measured by changes in the
index.
• If the CPI rises from 100 to 105.6 during the year,
the annual rate of inflation is 5.6 percent.
• The impact of inflation on individuals depends on
the extent to which they consume the particular
goods whose prices are inflating.
• Some analysts argue that the CPI overstates the
true rate of inflation.
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• Deflation:
• A general decline in prices, the real
purchasing power of assets and income rises
as the prices of goods and services decline.
• Inflation has been a common occurrence,
but deflation is rare.
• While prices of specific goods and services
may decline in response to lower demand or
to lower costs of production, prices in
general tend to be “sticky”
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The Federal Reserve (the Fed)
• The nation's central bank
• Purpose: to control the supply of money in order to
achieve
– stable prices
– full employment
– economic growth
• Easy monetary policy: Federal Reserve wants to increase
the supply of money and credit to help expand the level
of income and employment.
• Tight monetary policy: desires to contract the supply of
money and credit to help fight inflation
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Determination of Interest
Rates
• Depend on the demand for and supply
of loanable funds
• Affected by the actions of the Fed
• As interest rates decline, the quantity
demanded of loanable funds increases &
vice versa.
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Increase in Supply of Funds
Lowers Interest Rates
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Decrease in Supply of Funds
Increases Interest Rates
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A Specific Interest Rate
• Can be calculated as
i = ir + Pi + Pd +Pl+ Pt.
The current nominal interest rate (i) is the sum of
the real risk-free rate (ir) and a series of risk
premiums which are
– expected inflation (Pi)
– possibility of default(Pd)
– Liquidity(Pl)
– term to maturity (Pt)
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• The real risk-free rate is the return investors earn
without bearing any risk in a noninflationary
environment.
• The inflation premium depends on expectations
of future inflation. A greater anticipated rate
argues for a higher rate of interest.
• The default premium depends on investors’
expectations or the probability that the lender will
not pay the interest and retire the principal.
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• The liquidity/marketability premium is related to
the ease with which the asset may be converted
into cash near its original cost.
• Term to maturity: the term premium is associated
with the time (or term to maturity) when the
bond will be redeemed.
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Impact of The Federal Reserve
• The Fed affects interest rates through its
impact on the ability of the banking system
to lend. That is , it uses its power to change
the money supply by using the tools of
monetary policy.
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The Tools of Monetary Policy
– The reserve requirements of banks
– The discount rate
– open market operations.
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The reserve requirement
• The percentage set by the Federal Reserve that
depository institutions must hold against deposit
liabilities.
• It is divided into required and excess reserve
• If the reserve requirement is 10 percent and $100 cash is
deposited, $10 must be held against the deposit (the
required reserve) and $90 is available for lending (the
excess reserves).
• Changing commercial banks' reserves affects the
capacity of banks to lend and thus affects the supply and
cost of credit.
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The discount rate
• The rate of interest that the Federal Reserve
charges banks for borrowing reserves.
• By borrowing the necessary reserves, banks will
not have to liquidate assets in order to obtain the
funds to meet their reserve requirements which
means maintaining the supply of money and
credit.
• changes in discount rate are only symbolic means
to alter supply of money and credit.
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Open market operations
• The buying and selling of federal government securities.
• When the Fed follows an expansionary policy, it purchases
securities & the funds are deposited into commercial banks
which will in return loan these funds & thus cause an
increase in the supply of money and credit.
• When the Fed follows a tight (contractionary) monetary
policy ,it sells securities & the funds paid for flow out of
banks which will drain the reserves from the banking
system ,decrease its ability to lend & contracts the supply of
money and credit.
• Have a direct impact on interest rates.
• The most important tool of monetary policy.
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Monetary Expansion
• To expand the money supply, the
Fed buys government securities.
• The purchases reduce interest
rates
• Paying for the securities puts
reserves into the banking system
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Monetary Contraction
• To contract the money supply, the
Fed sells government securities
• The sales increase interest rates
• Receiving payment for the
securities removes reserves from
the banking system
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Impact on Stock Prices
• Changes in monetary policy affect stock prices through:
1-Changes in require return:
Example: higher risk-free rate would lead to a higher
required return and lower stock valuations.
2-Changes in a firm’s earning capacity:
Example: Reducing cost of credit may increase earnings
resulting in higher dividends & more growth through
retained earnings.
• A change in interest rates is transferred to stock prices:
higher interest rate reduces earnings & ability to pay
dividends.
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Fed Watching
• Investors watch the Fed with the hope of
anticipating the next change in monetary policy.
• The Federal Open Market Committee (FOMC)
-The most powerful component of the Fed.
-has control over open market operations
• The watching involves the meetings and the
statements of FOMC and Board of Governance.
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Money Supply
• The Fed uses two definitions of money supply:
• M-1 sum of cash, coin, and checking accounts
(narrow or simple definition)
• M-2 sum of cash, coin, checking accounts, plus
savings accounts (broader definition)
• shifting funds from savings accounts to checking
accounts will
-increase money supply under (M1)
-not affect money supply under the broader
definition (M2)
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Money Supply
• The monetary base:
-An alternative measure of monetary policy
-the sum of coins, paper money & bank reserves
kept within a bank or at the Fed.
• The growth in the money supply is related to
economic growth and economic growth is related to
stock prices.
• Over time the money supply increases
• The rate of increases varies
• M-1 and M-2 do not always move together
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Money Supply
• Developing a successful investment strategy
based on monetary policy is difficult as the
market anticipate the changes.
• To use changes in monetary policy as a guide
for an investment strategy,
• It is necessary to differentiate between
-expected changes (the effects reflected in
stocks’ prices)
- unanticipated changes (which have an impact
on stock prices)
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Fiscal Policy
• The federal government's management of:
– taxation
– Spending
– debt management
• Fiscal policy goals:
-price stability
-full employment
- economic growth
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Taxation
• Taxation:
-Corporate income taxes : reduce earnings ,
firms’ capacity to pay dividends and to retain
earnings for growth.
-Personal income taxes: reduce disposable
income.
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Deficit Spending
• Government spending exceeds
revenues
• Sources of funds to finance the
deficit
– commercial banks
– non-bank public
– Federal Reserve
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Surplus
• Government revenues exceed
Expenditures
• Question of how to use any surplus
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Fiscal Policy
• The possible impact of deficit
spending or a surplus on
–the money supply
–the reserves of the banking
system
–security prices
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The 2008–2012 Economic Environment
• Fiscal policy and deficit spending changed in
reaction to the events of 2007–2008.
• There was expansionary monetary policy by
driving interest rates to historic lows.
• The Fed extended its purchases to include a
variety of debt instruments in addition to selling
&buying of treasury.
• The expectation of inflation changes investor
psychology and strategies.
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Industry Analysis
• The growth and maturation of an industry
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Cyclical & Non-cyclical
Industries
• Cyclical firms are more sensitive to
changes in the level of economic
activity
• Non-cyclical firms are less sensitive
to changes in the level of economic
activity
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The Economic Environment
and Investment Strategies
• Firms respond differently to economic
changes
• Changes that damage one firm or
industry may help other firms and
industries
• For example, higher oil prices may
help oil producing and exploration
firms but hurt utilities and airlines
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Changes in Interest Rates
• Affect firms with substantial amount
of debt such as
–utilities
–banks
–airlines
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Changes in Interest Rates
• Affect demand for some products
–Consumer durables
–Housing
–Automobiles
–Deferrable purchases
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Changes in Inflation
• Affect firms with natural resources
– Oil
– Precious metals (e.g., gold)
• Some firms are better able to pass on price
increases
• Inflation will lead to higher interest rates for
debt for variable-rate debt securities.
• The interest payments will increase in response
to the higher rates and offset the impact of
inflation.
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• Exchange-traded funds (ETFs) permit investors
to establish positions in precious metals,
commodities, and currencies without having to
select specific assets.
• Possible ETFs for currencies include the
following:
• Currency Shares Euro Trust (FXE)
• British pound (FXB)
• Canadian dollar (FXC)
• Australian dollar (FXA)
• Swiss franc (FXF)
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Deflation
• A general decline in prices
• Opposite impact of inflation
• Hurts debtors and helps creditors
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Recession and
Economic Stagnation
• Help firms producing consumer
necessities
• Importance of anticipation
–Fed lowering interest rates to
stimulate the economy
–changes in fiscal policy to
stimulate the economy
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