Framework and Macro Considerations Flashcards
Elaborate on the framework and challenges of CME
Asset allocation is the primary determinant of the long run portfolio performance. The focus should not be on accurate forecast of one asset class but rather on internal consistency across asset classes (cross sectional and intertemporal consistency).
Step in the framework to develop CME
1) Specify the set of expectation needed including the time horizon to which they apply.
2) Research the historical record and factor that affect the asset performance
3) Specify the model and their information performance.
4) Determine the best sources of information
5) Interpret the current investment environment using the selected data and method applying experience and judgement
6) Provide the set of expectation needed and document conclusion
7) Monitor the actual outcome and compare against the forecast.
What are the challenges in forecasting ?
Limitation of economic data Data measurement error and biases Limitation of historical estimate Ex post risk can be biased measure of ex ante risk Bias in analysts methods Failure to account for conditional information Misinterpretation of correlation Psychological biases Model uncertainty
What are the causes of exogeneous shock to growth ?
Policy changes New products and technologies Geopolitics Natural disasters Natural resources Financial crisis
Elaborate on the decomposition of GDP growth and issues in forecasting
-Growth from labor input
growth in labor size
growth in labor participation
-Growth from labor productivity
Increase capital input
Increase TFP
Elaborate on anchoring assets returns to trend growth ?
Both theory and empirical evidence suggest that the level of default-free bond yield is linked to the trend rate or real money growth.
Vt = GDPt * St * PE
In the long run the equity valuation is linked to the growth of GDP
Market return = Real GDP +infl + EPS/GDP + PE + Div Yield
Elaborate on high GDP growth and equity return
Studies shows that countries with high economic growth rates do not reliably generate higher equity market returns. A partial explanation is that the higher growth rate was already reflected in market prices. If capital stock is growing rapidly, the rate of return on invested capital may be driven down.
What are the main approaches for forecasting
Econometric modeling
Economic indicators
Checklist Approach
Elaborate on Econometric modeling
- Structural models
- Reduced form models
Econometric models are widely regarded as very useful for stimulating the effects of changes in key variables. It constraints the forecaster to a certain degree of consistency. The may exhibit critical limitation s such as unavailability of key input, data measure error or changes in relationship.
Elaborate on Economic indicators
- LEI (leading economic indicator)
- Diffusion index (how many LEI are pointing up)
Elaborate on Checklist Approach
Flexible but very subjective
Elaborate on business cycles
They can vary both in intensity and duration. Much of the uncertainty that sustain the uncertainty is endogenous (suppliers, employers, creditors, customers, policy makers do not behave as expected). Other sources of uncertainty are exogeneous (tech, Natural disaster, geopolitical events).
Elaborate on the phases of business cycles
Initial recovery Early expansion late expansion slow down contraction
Elaborate on Initial recovery and Early expansion
Initial recovery small cap, EM bonds 6 equities higher corp. yield typically perform well. Stock may rise briskly.
Early expansion: Economy gain some steam. Profits rise rapidly. The stocks trend upward and the yield curve flattens. Longer maturity yield are set to remain stable or rise slightly.
Elaborate on Late expansion
Boom mentality prevails output gap has closed, employment is low, profit strong, wages and inflation are rising. Interest rate rise, equity become volatile but rising cyclical and inflation hedges such as commodities may outperform.
Elaborate on Slowdown and Contraction
Slowdown: the economy slowdown and confidence waivers. Quality stock such as utility may perform best
Contraction. may last 12-18 months, firm cut production sharply, monetary policy is eased.
Short term interest rate drop and credit spread widens.
Effect of inflation on asset classes
Cash: CBs aim to make the real rate of return on cash pro cyclical
Bond: The effect of inflation is transmitted through the discount rate. Rising inflation raises bond value. If inflation remains within the expected cyclical range, short term yield rise more than longer term yield but have less price impact because of lower duration. Deflation benefit highest quality bonds because it increases the purchasing power of cash.
Equity. There is little effect on stock as long as inflation keep up with expectations. Inflation benefits firms that can pass over costs.
Real estate. Positive correlation with RE value and income
Analysis of monetary policy
CB aim at being counter cyclical. They action are however plagued with lag and countercyclical.
Elaborate on the Taylor rule
I = r. neutral + exp. infl. +0.5(ye-ytrend) + 0.5(exp. infl.- target inf.)
Impactions of negative rate of interest for capital market expectation.
Negative rate are expected to produce the similar asset classes return to those occurring during “Normal contraction” or “early recovery”
However historical data become less reliable. Unconventional monetary policy tend to distort market relationship such as the shape of the yield curve and the performance of specific sector.
Elaborate on The Monetary and Fiscal Policy Mix
The mix of monetary and fiscal policies has its most apparent impact on the level of interest rates and the shape of the yield curve. The second impact of policy is on the slope of the yield curve. The slope of the term structure of (default-free) interest rates depends primarily on (1) the expected future path of short-term rates and (2) a risk premium required to compensate for the greater price volatility inherent in longer-maturity bonds. The maturity premium explains why the term structure is normally upward sloping. Changes in the curve’s slope—flattening and steepening—are primarily driven by the evolution of short rate expectations, which are mainly driven by the business cycle and policies.
Elaborate on The Shape of the Yield Curve and the Business Cycle
The shape of the yield curve is frequently cited as a predictor of economic growth and as an indicator of where the economy is in the business cycle.
Elaborate on international transactions
In general, the dependence of any particular country on international interactions is a function of its relative size and its degree of specialization. Large countries with diverse economies, such as the so-called G–7 (the United States, United Kingdom, Germany, France, Italy, Japan, and Canada), tend to be less influenced by developments elsewhere than smaller economies, such as Chile, whose output depends significantly on a few commodities
Elaborate on Macroeconomic Linkages
(X – M) = (S – I) + (T – G)
domestic saving plus taxes.
There are four primary mechanisms by which the current and capital accounts are kept in balance: changes in income (GDP), relative prices, interest rates and asset prices, and exchange rates. Strictly speaking, all of these tools can play a role in both the real economy (the current account and FDI) and the financial markets, and they are determined simultaneously.
