Capital Market Expectations Flashcards
Discuss the role of, and a framework for, capital market expectations in the portfolio management process.
Capital market expectations help in formulating the strategic asset allocation. They can also assist in detecting short-term asset mispricings exploitable through tactical asset allocation. Asset allocations should display both cross-sectional and intertemporal consistency.
To formulate capital market expectations, use the following process:
* Determine the relevant capital market expectations given the investor’s allowable asset classes and investment horizon(s).
* Investigate assets’ historical performance as well as the determinants of their performance.
* Identify the valuation model used and its requirements.
* Collect the best data possible.
* Use experience and judgment to interpret current investment conditions.
* Formulate capital market expectations.
* Monitor performance and use it to refine the process.
Discuss challenges in developing capital market forecasts.
Limitations in the use of economic data for forecasting include the following:
* Data are reported with a lag, subject to revision, and defined inconsistently in different countries.
* Data are subject to biases and errors such as transcription errors, survivorship bias, and smoothed (appraised) data estimates.
* Using historical data is less appropriate when economic conditions change (regime change and nonstationary issues).
* Ex-post risk generally understates ex-ante risk, as surviving the past does not guarantee the future cannot be worse.
* Data mining or selection of time periods may introduce biases.
* Models should be conditioned for the likely state of the economy.
* Correlation does not imply causation. Does A cause B, does B cause A, or are both associated with some other factor C?
* Psychological biases and cognitive errors may affect an analysis.
* Models, parameters, and inputs are subject to uncertainty.
Explain how exogenous shocks may affect economic growth trends.
Exogenous shocks are unanticipated events that occur outside the normal course of an economy and may have either a positive or negative impact on growth. They can be caused by different factors, such as changes in government policies, political events, technological progress, natural disasters, discovery of natural resources, and financial crises.
Discuss the application of economic growth trend analysis to the formulation of capital market expectations.
In forecasting a country’s long-term economic growth trend, the trend growth rate can be decomposed into two main components and their respective subcomponents:
* Changes in employment levels, which are related to population growth and labor force participation.
* Changes in productivity, which are related to capital inputs and technological advancement.
Compare major approaches to economic forecasting.
Econometric analysis uses statistical methods to formulate forecasting models. These models range from being quite simple to very complex, involving several data items of various time period lags to predict the future.
Economic indicators attempt to characterize an economy’s phase in the business cycle and are separated into lagging indicators, coincident indicators, and leading indicators. Analysts prefer leading indicators because they help predict the future path of the economy.
In a checklist approach, the analyst checks off a list of questions that should indicate the future growth of the economy. Given the answers to these questions, the analyst can then use her judgment to formulate a forecast or derive a more formal model using statistics.
Discuss how business cycles affect short- and long-term expectations.
Understanding business cycle phases is important for forming capital market expectations, but their relationship is not straightforward. Business cycles vary in duration and intensity, and their turning points are difficult to predict. It can be difficult to distinguish among factors that arise from the business cycle and factors that affect the trend rate of growth. Returns in the capital market are strongly related to activity in the real economy, but also depend on factors such as investors’ expectations and risk tolerances.
The business cycle can be subdivided into five phases:
1. initial recovery
2. early expansion
3. late expansion
4. slowdown
5. contraction
Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns.
Inflation varies over the business cycle, rising in the latter stages of an expansion and falling during a recession and the initial recovery. Deflation reduces the value of investments financed with debt (e.g., real estate) because leverage magnifies losses.
Bond prices will rise during a recession when inflation and interest rates are declining. In a strong expansion, bonds tend to decline in price as inflation expectations and interest rates rise.
Equities provide an inflation hedge when inflation is moderate. High inflation can be problematic because slow growth may result from central bank action to combat inflation. Deflation is harmful because it encourages defaults and limits the scope for monetary policy.
Discuss the effects of monetary and fiscal policy on business cycles.
Central banks often use monetary policy as a countercyclical force. The goal is to keep growth near its long-run sustainable rate, because growth faster than the long-run rate usually results in increased inflation. To spur growth, a central bank can take actions to reduce short-term interest rates.
The Taylor rule determines the target interest rate using the neutral rate, expected GDP relative to its long-term trend, and expected inflation relative to its targeted level:
n target = r neutral + i expected + [0.5(GDP expected − GDP trend) + 0.5(i expected − i target)]
- A central bank can use the Taylor rule to determine the appropriate level for short-term interest rates.
- An investment strategist who expects unanticipated changes in the inputs to the Taylor rule can use the rule to anticipate changes in short-term interest rates by the central bank.
Another tool at the government’s disposal for managing the economy is fiscal policy. If the government wants to stimulate the economy, it can implement loose fiscal policy by decreasing taxes or increasing spending, thereby increasing the budget deficit. If they want to rein in growth, the government does the opposite to implement fiscal tightening.
Interpret the shape of the yield curve as an economic predictor and discuss the relationship between the yield curve and fiscal and monetary policy.
The yield curve demonstrates the relationship between interest rates and the maturity of debt securities. The curve is sensitive to government actions as well as current and expected economic conditions.
When both fiscal and monetary policies are expansive, the yield curve is sharply upward sloping, which indicates that the economy is likely to expand in the future. When fiscal and monetary policies are restrictive, the yield curve is downward sloping, indicating that the economy is likely to contract in the future.
When fiscal and monetary policies are in disagreement, the shape of the yield curve is less definitively formed. If monetary policy is expansive while fiscal policy is restrictive, the yield curve tends to be upward sloping, though less steep than when both policies are expansive. If monetary policy is restrictive while fiscal policy is expansive, the yield curve tends to be flatter.
Identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies.
Macroeconomic links refer to similarities in business cycles across countries. Economies are linked by both international trade and capital flows so that a recession in one country dampens exports and investment in a second country, thereby creating a slowdown in the second country.
Exchange rate links are found when countries peg their currency to others. The benefit of a peg is that currency volatility is reduced and inflation can be brought under control. Interest rates in the pegging country often reflect a risk premium relative to the country to which it pegs.
Interest rate differentials between countries can also reflect differences in economic growth, monetary policy, and fiscal policy.
Discuss approaches to setting expectations for fixed-income returns.
The three approaches to forecast fixed income returns are the DCF method, the risk premium approach, and the equilibrium model.
The DCF method is used to estimate the required return of an asset. It is the most precise method for fixed income securities. It includes analysis of the YTM and the Macaulay duration. The Macaulay duration will determine whether an expected yield change will generate positive or negative returns (by looking at its impact on prices vs. return from reinvestment of cash flow).
The risk premium (or building block) approach starts with the risk-free rate and adds on different risk premiums, including the term premium, credit premium, and liquidity premium.
The short-term risk-free rate can be estimated from government zero-coupon yields. The term premium is positively related to duration and the slope of the yield curve, and is influenced by inflation uncertainty, recession hedges, supply and demand of bonds, and business cycle movements.
Credit premiums compensate for the expected level of losses and for the risk of default losses, and are also positively related to the slope of the yield curve.
Steep yield curves generally indicate both high credit and term premiums, both of which are considered bullish indicators.
Liquidity tends to be highest for bonds that are
1. issued at close to par or market rates
2. new
3. large in size
4. issued by a frequent and well-known issuer,
5. simple in structure
6. of high credit quality.
Liquidity premiums can be established by comparing the yield spread between the highest quality issuer (usually the sovereign) and the next highest quality issuer.
Discuss risks faced by investors in emerging market fixed-income securities and the country risk analysis techniques used to evaluate emerging market economies.
Investors in emerging market debt face higher risks associated with the foreign government’s ability and willingness to repay its obligations, and are exposed to other political, legal, and economic risks.
Indicators of heightened credit risk in emerging market bonds include (1) deficit-to-GDP ratio greater than 4%; (2) debt-to-GDP ratio greater than 70%–80%; (3) real growth rate less than 4%; (4) a current account deficit exceeding 4% of GDP; (5) foreign debt levels greater than 50% of GDP or debt levels greater than 200% of the current account receipts; and (6) foreign exchange reserves less than 100% of short-term debt.
Discuss approaches to setting expectations for equity investment market returns.
Equity market returns can be estimated using the DCF analysis, a risk premium approach, and the equilibrium approach.
The DCF analysis can also be used for equity valuation and establish the intrinsic value of an asset as the present value of its future cash flows.
The Grinold-Kroner model calculates the expected equity return as its dividend yield plus the inflation rate plus the real earnings growth rate minus the change in stock outstanding plus changes in the P/E ratio.
The Grinold-Kroner model can also be viewed as the (1) expected cash flow return (dividend yield minus change in shares outstanding), (2) nominal earnings growth (real earnings growth plus inflation), and (3) expected repricing return (change in the P/E ratio).
The risk premium approach looks at the equity risk premium as the amount by which the equity return exceeds the expected return of a default-free bond. However, forecasting the equity premium can be challenging.
The Singer-Terhaar model combines two versions of the international CAPM: one in which global asset markets are fully integrated and another in which markets are fully segmented.
The Singer-Terhaar model calculates the risk premium for an asset in a fully integrated market as the product of its correlation with the global market portfolio and the standard deviation of the asset, multiplied by the Sharpe ratio of the global portfolio. The model calculates the risk premium for an asset in a fully segmented market as the product of the standard deviation of the asset and its Sharpe ratio plus any illiquidity premium.
The Singer-Terhaar model then calculates the asset’s overall risk premium as the weighted average of the risk premiums calculated under full integration and full segmentation.
Discuss risks faced by investors in emerging market equity securities.
Emerging equity markets tend to be characterized by political and policy instability, weaker legal protections, and weak disclosure and enforcement standards. Emerging markets tend to be more segmented than developed markets.
Explain how economic and competitive factors can affect expectations for real estate investment markets and sector returns.
Real estate values are subject to business cycle movements, including boom (higher demand drives up property values) and bust (falling demand drives values and lease rates down).
Real estate valuation is measured by the cap rate, which is calculated by dividing current NOI by the value of a commercial real estate property.
Real estate returns include a term premium for holding long-term assets, a credit premium to compensate for the risk of tenant nonpayment, and an equity risk premium above corporate bond returns for the fluctuation in real estate values, leases, and vacancies.
REITs are generally strongly correlated with equities in the short term, while direct real estate shows low correlation, although the low correlation is partly due to the smoothing of return data.
Over the very long run, residential real estate has outperformed equities on a real basis with lower volatility, although their return has been relatively weak over the last 40 years.
