Capital Market Expectations

Question 1

Long-term economic growth trend formula? (Long-term GDP Trend)

Split the components into two subcategories and explain them

Is the GDP growth rate a real or nominal number?

If expected inflation isn’t given, how else can you get to it?

* remember - Trend GDP is typically above 0 (expecting economies to grow over long term)

Answer 1

Long-term GDP Trend = Population growth + Labour force participation + New Capital Inputs + TFP

This is Real GDP Growth, so:

Nominal GDP Growth = Real GDP Growth + inflation

1) Growth from labour inputs
- g in potential labour force size: the more people you have to enter the work force, higher potential GDP
- g in actual labour force participation rate: people wanting to work, new entrants with fewer exits = growth in participation rate
2) Growth from labour productivity
- g from increasing capital inputs: capital deepening - more capital also, tax savings = higher savings which is = higher investment back in to new machinery, inventory etc

Savings = investments

• g in TFP: replacing capital with more productive capital or training your workforce (upskilling)

Expected inflation rate = 20yr TIPS - 20yr Treasury Yield

Question 2

Taylor Rule - what is it for and what is the formula?

Answer 2

The Taylor Rule is used to state what the Central Bank (Monetary Policy) should do. It’s a pretty good indicator.

Formula: rtarget = rneutral + πe + 0.5(GDPe - GDPtrend) + 0.5(πe - πtarget)

GDPtrend = LT trend in GDP growth

Neutral rate = real short-term (30 days or overnight) policy rate that would be targeted if growth is expected to be at trend and inflation on target. Inflation + real growth

Can also be expressed as: Real inflation adjusted target rate, just move πe to left of the equation.

Question 3

Exogenous Shocks

1) What are exogenous shocks?
2) List examples of exogenous shocks

Answer 3

ES = unanticipated events that occur outside of the normal course of an economy.

Not already built into prices.

ES can be positive or negative

1) Discovery of natural resources
2) Financial crises
3) Changes in government policy
4) Political events
5) Natural disasters
6) Technological progress
7) Critical inputs

Question 4

What is an Output gap?

Answer 4

Output gap = Actual GDP - Trend GDP

Inflationary gap = Actual GDP > Trend GDP

• economy performing above trend GDP
• high demand for labour & goods: inflation!

Recessionary gap = Actual GDP < Trend GDP

• economy performing below trend GDP
• lack of demand for goods & services

A RG happens when people are not spending, lower inflation or disinflation.

It is when Actual GDP is lower than Potential GDP

Question 5

What is the expected return on Equity for the economy?

Aggregate MV of equity for an economy?

Answer 5

E(R^e) = D/P + V^e

• D/P = Div Yield (Income component) - Div/MV
• V^e = Capital Appreciation (Growth component)

Aggregate MV of Equity

Capital Appreciation: V^e= GDP_t + S_t + P/E_t

• GDP_t = Nominal level of GDP (Trend GDP which is real so + infl)
• S_t = Share of corporate profits in economy (E/GDP)
• P/E_t = PE ratio (stable in long run)

Mainly driven by GDP_t

Question 6

List the different stages of the business cycle and what is happening with inflation at each stage

Answer 6

1) Initial recovery - initially declining inflation
2) Early expansion - low inflation
3) Late expansion - increasing inflation
4) Slowdown - inflation continues to accelerate
5) Recession - Inflation peaking

Question 7

Describe Initial Recovery stage of the business cycle

Answer 7

Initial recovery: Steep YC

• Economy picking up from slowdown/recession, business confidence rising, consumer confidence still low (lags business confidence)
• Fiscal & Monetary stimulus still present, inventory upswing (companies rebuilding inv)
• Infl - initiall declining

CME - ST rates low, gov yields bottoming therefore bond prices peaking

• Stocks prices increasing
• Cyclical + risky assets outperform as they attract investors (HY Bonds, EM Stocks/Bonds)

Question 8

Describe Early Upswing stage of the business cycle

Answer 8

Early Upswing: YC begins to flatten

• Confidence grows (both cons and bus), economy gains momentum without inflation (very low still)
• Unemployment starts to fall, business investment picks up
• Infl: Low inflation still (output gap still negative)

CME: ST interest rates rising as CB begins withdrawing stimulus, LT rates stable or slightly rising

• Bonds prices beginning to decline
• Stocks rising
• Withdrawing stimulus

Question 9

Describe Late Upswing stage of the business cycle

Answer 9

Late Upswing: Curve flattening

• Output gap (Actual GDP - Trend GDP) closed
• Confidence high, unemployment low, wages grow
• Infl: Increasing inflation (looming)

CME: ST & LT rates rising as monetary policy becomes tighter

• Bond prices declining
• Stocks rising (and peaking) but volatility rising as well
• inflation hedges such as commodities outperform
• Monetary policy shifts from expansionary to hawkish (tight)

Question 10

Describe Slowdown stage of the business cycle

Answer 10

Slowdown: Yield curve flat or can become inverted

• Economy slowing
• Business confidence dropping
• Downswing in inventory (working down inventory)
• Infl: strong, continues to accelerate as firms raise prices to stay ahead of rising costs

CME: ST rates topping out (and LT rates possibly topping out/dropping)

• Bonds begin to rally (long bonds by more)
• Stocks soft/falling

Question 11

Describe the Recession stage of the business cycle

Answer 11

Recession: YC steep again

• Large inventory pullback
• Cons and Business conf declines
• Drop in business investment, durable goods sales drop
• Infl: Peaking

CME: ST rates drop as do all bond yields

• Long rates drop but not by as much: CB dropping ST rates as they ease monetary policy so left with an upward sloping YC
• Stocks drop and bottom out before end of recession

Question 12

National accounting equation

Answer 12

X - M = (S - I) + (T - G)

Current Account = Capital Account

Trade deficits financed by - Net savings and Government surplus

As Current account changes, int rates (incr), FX (incr), Asset prices (dec) change to keep the capital account in balance

X = Exports

M = Imports

S = Savings

I = Investment

T = Taxes

G = Government spending

1) If in deficit (Imp > Exp) - need people to save more and invest less: offer higher real rates

Question 13

Inflation = Procyclical

1) Why?

Answer 13

At the trough of the business cycle = steep upward slope

• ST: low inflation expectation
• LT: high inflation expectation (at the top of the curve)

* think - you’re at the trough, in short time periods i.e. 1, 3 months out, infl will still be very low therefore you have low inflation expectatoin. From the trough viewpoint looking out 20 months, you expect the economy to be peaking therefore inflation expection will be high.

At the peak of the business cycle = downward slope

• ST: High inflation expectation
• LT: Low inflation expectation

Question 14

Inflation and it’s effects on:

1) Cash
2) Bonds
3) Equities
4) Real Estate

Answer 14

Starting point - thinking about it in 2 factors:

1) Cashflows and
2) Discount rate

1) Cash (int bearing short-term securities - 30 day)

• infl protected
• every 30 days, rolling into new 30 days at r_f + infl (effectively fl rate)
• attractive in rising rate environment

2) Bonds

• Cashflows fixed in nominal terms, no effect
• Discount rates affected by infl, rising infl lowers bonds prices

if:

Infl @ expectation - SR volatile (CB targeting) but low effect on bonds as low dur at short end

Infl above expectation - LT rate volatility! Higher LT rates = massive price decreases

Deflation benefits IG Bonds, but not HY Bonds

3) Equities

• Value = CF/(1+r): num and den both move with infl

Infl @ expectation - little effect due to above

Infl above expectation - negative effect unless can pass on to customers

Infl below expectation - decline in asset prices

4) Real Estate
- Rents and property values increase with inflation
- Not good with deflation

Question 15

The Taylor Rule

1) What is it used for?
2) Formula?
3) Variations?

Answer 15

1) Used to identify what the CB target rate should be
2) r_target = r_neutral + π_e + 50%(GDP_e-GDP_Trend) + 50%(π_e-π_Target)
- r_target: nominal target rate
- r_neutral: can use 30 day rate from YC Chart. It is the rate at which a balance between growth and inflation is achieved. Only split them up if it’s given as a “real” number

Question 16

Fiscal and Monetary policy

Answer 16

High nominal rates

FP Loose - High real rates

MP Loose - Low exp infl

Low nominal rates

FP Tight - Low real rates

MP Tight - Low exp infl

Remember - Gov (FP) issues debt (not CB) therefore rates affected

Loose FP = budget deficit = new gov debt issues = supply>demand so prices drop and yields increase

Also trying to attract capital inflow to fund deficit, increase yields to make attractive

Loose MP = trying to stimulate - you’re at the trough

trough = low exp infl ST but high exp infl LT so high expected infl

Question 17

Forecasting Equity Returns:

Expected return for a market?

Variations?

Answer 17

E(r) = D₁/P_o + g

• g: capital appreciation (Trend GDP)

Grinold-Kroner

E(R_e) = (D/P - %S) + %E + %P/E

• %S: change in shares outstanding: issue more = -%S
  repurchase: -(-%S) (buybacks add to return)

%E = Expected nominnal earnings growth rate

• two components to it, change in earnings and long term g, which is 6%.

Question 18

Forecasting Real Estate returns:

1) Formula for Expected return on Real Estate:
1. 1) Long-run time period
2. 2) Short-run time period

If Cap Rates change, what is the effect on expected returns

Answer 18

Forecasting Real Estate returns:

1) Long-run time period

E(Re) = Cap Rate + g

Cap rate = NOI/Po (NOI in current period)

g = long run g (Growth in GDP) - Nominal growth rate

2) Short-run period

E(Re) = Cap Rate + g - %change(NOI/Po)

%change(NOI/Po) = (Cap rate t+1/Cap ratet)^1/t

3) Cap rates change

• if cap rates are decreasing: property values expected to increase therefore increasing expected returns - cap rate + g - (-%changecaperates)
• if told average lease = 5 years, grow Cap Rate at g for 5 years, then calc %change

Question 19

Forecasting Equity Returns

Risk Premium Approach

1) Formula for the risk premiums
2) Formula for R(E) using the risk premiums
3) Can it be used for any asset class? Yes

Answer 19

Singer-Terhaar

1) Fully Integrated

RP^G = Corr x vol x SR_m

2) Fully Segmented

RP^s = vol x SR_i

RP_i = _w(RP^{G) +} _(1-w)(RP^s)

_{w=degree of integration}

E(Re) = RP_i + r_f

Question 20

Cap Rates

1) What is their relation to interest rates?

Answer 20

Cap rates = procyclical with

• interest rates - higher interest rates - higher cap rates
• vacancy rates: higher vacancy means higher risk premium required by the investor
• credit spreads: think credit premiums - higher credit risk = higher return required

Cap rates = inversely related to

• availability of credit/debt financing: typically involve substantial leverage, therefore more debt available = lower liquidity premium required by investor

Question 21

Forecasting Currency Exchange rates

Trade deficits

Rebalancing

Effect of large/persistent deficits

Answer 21

Trade deficit = X

Lender nations may rebalance if their share of the currency becomes high

i.e. US been lending to RSA by buying our bonds and holding ZAR, may decide to sell bonds and ZAR to reduce their exposure,

This leads to downward pressure on the ZAR

Large/persistent deficits will lead to currency depreciation

• deficit nations: downward currency pressure
• surplus nations: upward currency pressure

Question 22

What is a Shrinkage Estimator?

1) Formula

Answer 22

Shrinkage estimator - combines two estimates into a more precise estimate

• applied when you believe simple historical results do not fully reflect expected future conditions
• weighted average estimate based on history & some other projection
• it’s a better estimate of population vcv

w(sample VCV matrix) + (1-w)(Target VCV matrix) = Final VCV matrix

Question 23

Dornbusch overshooting

Answer 23

Inflows into a country (assets undervalued)

Have to buy that currency

Stage 1 - Upward pressure on that currency (may already be overvalued)

Stage 2 - Consolidation

Stage 3 - Retraction