Lecture 2 - Macro and Economic Analysis Flashcards
Three Types of Portfolio Management
1) Passive
2) Structured
3) Active
What do passive portfolio managers believe?
Markets are efficient
What do structured portfolio managers believe?
Markets are mostly efficient
What do active portfolio managers believe?
Markets are inefficient
Fundamental Analysis
Market price of firm is tied to future earnings and dividends which is tied to the future business success of the firm.
Top-Down Approach Components
- Global Factors
- Country Specific Factors
- Sector Specific Factors
- Stock Selection
Global Factors
1) Political Risk
2) FX Risk
3) Global Growth Outlook
Domestic Macroeconomy goal is
Analyze the countries you want to invest in, in order to figure out which asset classes to overweight and underweight
Country Specific Factors
1) Current equity valuation levels
2) Fiscal Policy
3) Monetary Policy
4) Economic Indicators
5) Business Cycle
Demand Shock
An event that affects demand for goods and services in the economy
Supply Shock
An event that influences production capacity or production costs
How to resolve demand shock
1) Fiscal Policy
2) Monetary Policy
Fiscal Policy
Government’s spending and taxing actions
Monetary Policy
Manipulation of the money supply
Types of Economic Indicators
- Leading
- Coincident
- Lagging
Leadings Indicators
Rise and fall in advance of the economy
Coincident Indicators
Change at the same time as the economy
Lagging Indicators
Lag economic performance
Canadian Economic Indicators
- Money Supply
- Stock Market
- Commodity Prices
- Avg. workweek in manufacturing
- US leading indicator
Industry Analysis (Sector Specific)
There are a wide range of returns for different industries
Business Cycle
Recurring pattern of expansions and contractions in the economy
Components of a business cycle
- Peaks (Top of the cycle)
- Through (Bottom of the cycle)
Where are “financial stocks” in the business cycle and why?
Financial stocks usually excel when we head into a recessions since interest rates are dropping so the spread at which banks can earn profits increase as they usually delay passing on the cut of rates by central banks to their customers
Where are “consumer durables” in the business cycle and why?
Consumer durables outperform in the bottom of the recessions and interest rates are low and people take advantage of cheap financing
Where are “capital goods” in the business cycle and why?
Capital goods do well as we head towards a recovery as their customers (other businesses) want to see an increase in sales before they do any large purchases
Where are “base industries” in the business cycle and why?
Basic industries do well at the top of the cycle since they can pass on higher inflation in their end prices so profit margins stay constant
Where are “consumer staples” in the business cycle and why?
Consumer staples do well as we turn down towards a recession since people prefer low cost items prior to a recession.
Sector Rotation
Different industries/sectors are over-weighted or under-weighted based on the portfolio manager’s view of the current state of the business cycle
What types of changes can occur in an industry?
Cyclical or Structural
Cyclical Changes
Temporary changes caused by:
- Inflation
- Interest Rates
- International Economics
- Consumer Sentiment
Structural Changes
Permanent Changes caused by:
- Social Influences
- Technology
- Politics and Regulations
Industry Life Cycle Importance
Portfolio Managers need to be aware of the stage their industry/company are operating in
Industry Life Cycle Stages
1) Start-Up
2) Consolidation
3) Maturity
4) Relative Decline
Competitive Environment Factors
1) Threat of New Entrants
2) Bargaining Power of Buyers
3) Threat of Substitute
4) Bargaining Power of Suppliers
What monetary and fiscal policies might be prescribed for an economy in a deep recession?
Expansionary monetary policy to lower interest rates
Expansionary fiscal policy such as lower taxes, increased government spending, etc. would stimulate aggregate demand
Advantage of top-down approach
Provides a structured approach by incorporating the impact of economic and financial variables at every level in the analysis
You believe the Fed is going to loosen monetary policy, give investment recommendations for the gold mining industry
Expansionary monetary policy leads to increased inflation which increases the value of gold as gold is hedged against inflation
You believe the Fed is going to loosen monetary policy, give investment recommendations for the construction industry
Expansionary monetary policy will lead to lower interest rates which increases housing demand and thus will benefit the construction industry
Why is the index of consumer expectations a useful leading indicator?
If consumers are optimistic of the future, they will be willing to spend more money which increases demand and will stimulate the economy
Why is unemployment rate considered a lagging indicator
Economy has already started to turn down before employees are laid off.
Three ways by which central banks can influence money supply and credit in the economy
1) Changing the reserve requirement ratio
2) Adjusting the overnight discount rate
3) Open market operations (QE or QT)
What is an inverted yield curve?
An inverted yield curve happens with the 10-year yield is lower than the 2-year yield.
It reflects long-term interest rates falling below short-term rates.
Why is an inverted yield curve considered a leading indicator?
It is considered a leading indicator as this has been a predictor of an upcoming recession or near-term economic deadline.
Most recessions occurred within 12 months of the yield curve inversion.
What is the current state of the yield curve?
The yield curve keeps “uninverting”
What does the current state of the yield curve mean?
This means that a recession was starting or about to begin with short-term yield falling faster than longer ones
Advantage of using the Canadian Composite Indicator?
- Blend of many leading indicators that predict economic activity
- Designed to provide early signals or turning points
- Comprised of ten components which lead cyclical activity in the economy
Why is the U.S. Composite Index a leading indicator for Canada?
The U.S. is Canada’s largest trading partner
Three Main Forces
1) Productivity Growth
2) Short term debt cycle
3) Long term debt cycle
Why is credit so important?
Because the buyer is now able to increase his spending which drives the economy.
Creditworthy Borrower Requirements
1) Ability to repay
2) Collateral
Why does the debt cycle fluctuate?
Because when we borrow, we spend more than we can and when be repay, we spend less since we need to repay.
Productivity Growth
Illustrates the increase in living standard without the use of debt as individuals increase their income solely based off of their productivity
Short Term Debt Cycle Phases
1) Expansion
2) Peak
3) Contraction
4) Trough
5) Recovery
Expansion Phase
When spending continues to increase and prices rise since spending is fueled by credit
Why does inflation happen
People borrow more –> Spend more –> Causes less products to be available –> Prices for these products increase –> Banks increase interest rates to decrease spending
Why does deflation happen
Less borrowing –> Less money to spend –> less income for others –> Prices go down –> Recession –> Central banks will lower interest rates to increase borrowing again
How long does the short-term debt cycle last?
5-8 years
Long Term Debt Cycle
1) Early Growth: Low debt and high productivity with strong growth
2) Debt Accumulation: Borrowing rises as confidence growa
3) Debt Saturation: High debt levels
4) Deleverging: Debt reduction through 4 methods
5) Reset: Economy stabilizes
Deleverging
People cut spending –> Incomes fall –> Credit disappears –> asset prices drop since people sell collateral –> Lenders stop lending
Why doesn’t lowering interest rates work for deleverging?
Because interest rates are already low
How to fix deleveraging?
1) Cut Spending
2) Debts reduces
3) Redistribute wealth
4) Central Bank prints money
Austerity (Cut Spending)
Reduced spending to bring debt under control
Debt Restructing
Lenders get paid back less or over a longer period of time
Wealth redistribution
Governments tax the wealthy to redistribute money which then goes back to the central government
Printing money
Central banks print money so people can repay their debts and inject liquidity into the economy
Quantitative Easing
1) Central banks decide to use QE
2) Central banks create new money
3) Central banks buy financial assets (bonds)
4) When assets are bought, financial institutions are paid which increases their reserves
5) Once they receive funds, their liquidity increases so they can lend/invest
6) Bond prices increase and their yields decrease
7) Interest rates decrease so people borrow more
8) More economic activity
9) Sell assets or let them mature
Quantitative Tightening
1) Central banks decide to do QT
2) Stop purchasing financial assets
3) Let QE bonds mature or sell assets
4) Bond prices decrease and interest rates increase
5) Bank reserves decrease so less borrowing
6) Less transactions so economy slows down
7) Inflation lowers
3 Rules of Thumb
1) Don’t have debt rise faster than income
2) Don’t have income rise faster than productivity
3) Do all that you can to raise productivity
