Capital Market Expectations Flashcards
What is the role of capital market expectations (CME) in the portfolio management process?
It represents expected risk and return properties of investor-defined asset classes.
It provides critical inputs to the investor’s strategic asset allocation and must result in realistic projections to help investors reach their goals.
What are the steps of the framework for capital market expectations in the portfolio management process?
- Expectations set and horizons
- Forecast range from past data
- Methods/models and inputs
- Best information sources
- Implement based on current market
- Documented conclusions, expectations
- Feedback based on results
What are the 3 challenges in developing capital market forecasts?
Input uncertainty: Related to errors in the underlying data (accuracy, timeliness, variable definition, smoothed data, survivorship bias, regime change).
Model uncertainty: Choosing the conceptually and structurally correct model (nonstationarity, autocorrelation, etc.).
Parameter uncertainty: Related to errors in estimated parameters.
Explain what are the 3-types of exogenous shocks and how they may affect economic growth trends?
Exogenous shocks: involve external policy changes, geopolitics, natural disasters, or financial crises.
Type 1: A permanent, one-time decline with resumption of the trend rate after the initial shock.
Type 2: No persistent one-time decline, but continuation at a lower trend rate.
Type 3: Both a permanent, one-time decline and continuation at a lower trend rate.
How does the application of economic growth trend analysis to the formulation of capital market expectations as it pertains to inputs to growth?
Labor input growth:
* Increases in hours worked
* Increase in size of labor force (population growth)
* Increase in labor force participation rate
Labor productivity growth:
* Increasing capital inputs
* Total factor productivity (TFP) increase (technology improvement)
What is the application of economic growth trend analysis to the formulation of capital market expectations as it pertains to equity market valuation?
Default-free bond rates (e.g., U.S. Treasuries) link to GDP growth trend.
Aggregate equity market value is related to GDP growth, where:
* GDP is gross domestic product, S^k equals capital’s share of income (corporate earnings as a percentage of GDP)
* PE is the price-to-earnings ratio.
What are the 3 major approaches to economic forecasting?
Econometrics: Uses statistical methods to model relationships among economic variables.
Economic indicators: Statistics representing lagging, concurrent, or leading view of an economy. A diffusion index determines a direction based on up versus down indicators.
Checklist approach: Analyst assesses data pointing in one direction or the other.
What are the strengths and weaknesses of econometrics?
Strengths:
* Many factors help represent reality; robust (valid statistical relationship).
* Quickly updated using new data.
* Provides quantitative estimates.
* Imposes analytical discipline and consistency.
Weaknesses:
* Complex, time-consuming.
* Forecasting inputs is difficult.
* Model may be misspecified due to changing relationships.
* False precision impression.
* Turning points hard to forecast.
What are the strengths and weaknesses of leading indicators within economic forecasting?
Strengths:
Intuitive and simple.
Focuses on turning points.
Available from third parties.
Easy to track.
Weaknesses:
Can provide false signals.
Binary (yes/no) directional guidance.
Subject to frequent revision.
What are the strengths and weaknesses of checklist approaches?
Strengths:
* Not overly complex.
* Can include a wide variety of check points (breadth).
* Flexible; easily incorporates structural changes and items easily added/dropped.
Weaknesses:
* Arbitrary, judgmental, and subjective.
* Manual process that limits ability to combine different types of information.
* Time consuming.
How does the business cycles affect short- and long-term expectations in the initial recovery phase?
Short-and long-term government bond yields are likely to be bottoming but may still decrease.
Stock markets may begin to rise quickly as recession fears subside.
Riskier small-cap stocks, high-yield bonds, and emerging market securities start to do well.
How does the business cycles affect short- and long-term expectations in the early expansion phase?
Short rates begin to increase; long rates remain stable or increase slightly
Flattening yield curve
Stock prices trend upward
How does the business cycles affect short- and long-term expectations in the late expansion phase.
Private sector borrowing causes rates to rise.
Yield curve continues to flatten as short rates rise faster than long rates.
Stocks are volatile as investors watch for deceleration.
Inflation hedges (e.g., commodities) may begin to outperform other cyclical assets.
How does the business cycles affect short- and long-term expectations in the slowdown phase.
Long-term bonds may top but short-term rates continue to rise or may peak; yield curve may invert.
Credit spread widens, depressing bond prices for lower credit issues.
Stocks may fall; utilities and quality stocks are likely to outperform.
How does the Discuss how business cycles affect short- and long-term expectations in the contradiction phase.
Short- and long-term rates begin to fall; yield curve steepens.
Credits spread widens; remains wide until trough.
Stock market:
* Early phase – Declining
* Late phase – Begins to rise
What is the relationship of inflation to the business cycle?
Early recovery: Inflation is decelerating; stimulative policies remain in place.
Early expansion: Central banks remove stimulative policies; rates level.
Late expansion: Rising wages; inflationary fears; contractionary central bank policies.
Slowdown: Inflation continues.
Contraction: Rates continue to rise; inflation has peaked and may begin falling.
What are the implications of inflation for cash and bond returns?
Cash equivalents (not currency or zero-interest deposits): Short duration; attractive when rates rise and unattractive when rates fall.
Bonds: Due to fixed nominal cash flows, inflation effects are transmitted to yield via price changes:
* Within the expected inflation range – Shorter-term yields rise or fall more than longer-term yields, but the price impact is less due to duration.
* Outside the expected inflation range – Longer-term yields may rise more quickly.
What are the implications of inflation for equity returns?
The valuation process considers inflation in the discount rate applied to cash flows; inflation within an expectation range will have little impact on stock prices.
Higher inflation raises the discount rate and decreases valuations. Higher inflation benefits companies that can pass on costs to consumers but harms companies that have little pricing power.
What are the implications of inflation for real estate return?.
Lease rates include an inflation expectation and, like stocks, inflation expectations within an expectation range will have little impact on asset prices.
The effect on asset prices of inflation outside the expectation range will depend on the length of underlying leases; shorter leases may be replaced with higher-rent leases at a faster rate.
Less-than-prime properties are most adversely affected by deflation, as they may have to cut rents to avoid losing renters.
What are the effects of monetary policy on business cycles?
Monetary policy shoulders most of the responsibility for cyclical mediation, although the government may have processes in place with countercyclical consequences.
Monetary and fiscal policy should be viewed as affecting either:
1. the interest rate level
2. the yield curve shape
What are the effects of tightening or loosening either monetary or fiscal policy on business cycles?
Fiscal Policy:
* Tight fiscal policy creates high real rates
* Loose fiscal policy creates low real rates
Monetary Policy:
* Tight monetary policy creates low inflation
* Loose monetary policy creates high inflation
Add the real rate impact of fiscal policy and the inflation expectation of monetary policy to determine the net policy effect.
What is the relationship between the yield curve and fiscal and monetary policy?
Rising nominal rates indicate rising economic activity and demand for funds, with possible central bank intervention to slow the economy.
When short-term rates are high and longer-term rates are lower, a recession is likely (inverted yield curve).
Interpret the shape of the yield curve as an economic predictor.
The yield curve steepens as the business cycle bottoms, flattens during expansion, becomes flat to inverted toward the peak.
As interest rates rise, and re-steepens during contraction. Shortest yields rise first during initial recovery.
How do changes to a current account affect a capital account?
Changes in the current account must be offset by changes to the capital account to balance the two accounts.
Because financial markets react more quickly to change than the real markets, changes to the current account reflect quickly in the capital account via short-term interest rates, exchange rates, and financial asset prices.
