9. Macroeconomic Risk Flashcards
Integration
Macroeconomic risk becomes more important, because markets become more integrated (more exposed to risk of other countries)
Global economy
Political risk (greater risks in global environment than found in US-based investments), exchange rate risk (changes prices of imports and exports)
Domestic macro economy:
- Stock prices rise with earnings, which depend on macroeconomic state.
- P/E ratios move within bounds, because of supply and demand.
o Low P/E -> buy, high P/E -> short sell.
o Exceeded bound in dotcom-bubble (normally 12-25).
Describe state of economy
GDP, industrial production, inflation, unemployment rate, consumer confidence.
Not that easy: benchmark is needed, some measures may point in opposite direction
Demand shock
Event that affects demand for goods and services in economy (government spending, lowering tax rates, more foreign demand)
- Demand shock increase will lead to increase in Y, r (more demand for credit) and ᴨ (move in same direction).
- More competition for capital (both government and enterprises).
Supply shock
Event that influences production capacity or production costs (lower imported oil prices, lower wages, better education)
- If supply shock increases Y moves opposite direction to r and ᴨ.
- Positive shock in oil prices (supply goes down).
Demand-side policy
- Fiscal policy
2. Monetary policy
Monetary policy
Manipulation of money supply to influence economy via interest rate policies.
EU didn’t do fiscal policy, because of long-run risk of inflation
o Open market operations
o Reserve requirements
Fiscal policy
Government’s spending and taxing actions by looking at budget deficit/surplus
(direct way to stimulate)
Fiscal policy
Deficit stimulates economy
o Increases demand for goods (via spending) more than it decreases demand (via taxes)
o Crowds out investments by firms (unfair competition -> survival based on non-market focus (government)
Monetary policy
Open market operations
Lending money to banks using bonds (cheaper for governments to get capital) as collateral to increase money supply (by ECB), demand goes up in short-term, inflation increases on long run.
- Deflation is dangerous, because consumers will postpone investments (deflation stops economy)
Monetary policy
Reserve requirements
- Banks need to hold certain reserve
- Effect on economy: increase reserve requirements to slow down economy
- Banks have less money to loan (10 times in 2007 in China)
- Never used in Western world, because of liquidity
Fiscal policy
Deficit stimulates economy
o Increases demand for goods (via spending) more than it decreases demand (via taxes)
o Crowds out investments by firms (unfair competition -> survival based on non-market focus (government)
Fiscal policy
Drawback of deficit
large deficit -> pay interest, loss of trust in government (inability to pay back debt) -> not risk-free anymore
Fiscal policy
Unemployment definitions
- U-3: standard unemployment rate
- U-4: U-3 plus discouraged workers: want to work, have actively searched for job
in past 12 months
What do we do about crisis?
- Increase government spending
- Offer banks opportunities to borrow against low rates
- Buy bonds/print money to lower interest rates -> last option
- Cut taxes, dangerous because government is already spending
Economic calendar
Macroeconomic announcements are on fixed dates, more variation in stock market
Actual announcement is not very important, predictions attached to announcement determines how market responds to announcement
Industry analysis
Returns are often strongly correlated within industries (assets bubbles are industry specific: insurance, railroads, technology), hard to perform different than industry-peers, but hard to define industry of diversified firm (codes get more specific with digit), economic performance can even vary across industries
Business cycles
Hard to predict business cycle, cycle will not look perfectly (unpredictable)
We don’t know where economy is in business cycle, too many factors that describe state of economy
Difficult to predict peak and trough, booms and recessions vary in length, length between peaks and troughs varies
- Cyclical industries
- Defensive industries
Cyclical industries
Above-average sensitivity to state of economy, high betas: producers of consumer durables (cars, PCs), technological
Invest during expansion
Defensive industries
Little sensitivity to business cycle, low betas: utilities, pharmaceuticals, food
Invest during contraction
Sensitivity to business cycle:
- Sensitivity of sales
- Operating leverage
- Financial leverage
Sensitivity of sales
Reflected in betas of firms, items that aren’t sensitive to income levels (necessities) versus discretionary goods (cars, machine tools, steel)
Operating leverage
Split between fixed and variable costs (high operating leverage -> more fixed assets), more sensitivity if larger part of costs is fixed (higher volatility), price doesn’t
depend on state of economy
Financial leverage
Use of borrowing, interest is fixed cost that increases sensitivity of profits
Sector rotation
Portfolio that is shifted to sectors that should outperform according to stage of business cycle: in peak inflation protection (commodities), in trough speculate on recovery (capital goods industries: PCs and cars)
Economic indicators
- Leading indicators: tend to rise and fall in advance of economy, forward looking (S&P500, consumer expectations)
- Coincident indicators: move with business cycle (industrial production, sales)
- Lagging indicators: change subsequent to market movements, can be measured afterwards (inflation, unemployment)
