Reading 10: Capital Market Expectations (Part 1)

Question 1

Long & Short Term Data

Answer 1

Pro: The recent three-year period is more likely to reflect the current economic and political environment.

Con: The recent shorter period does not reflect the full course of a business cycle or a variety of possible economic conditions.

Pro: The longer period is more likely to reflect various economic conditions that can occur.

Con: The longer period is more likely to be subject to regime change, be nonstationary, and reflect conditions that are no longer relevant.

Question 2

Diffusion Indices

Answer 2

Diffusion indices provide a check on economic indicators by quantifying the number of increasing components in the composite indicator versus decreasing.

Question 3

Economic Forecasting

Answer 3

Structural model (econometric) may give false sense of precision. Diffusion index (leading indicator) can provide false signals. Checklist approach is flexible with limited complexity but provides no consistency of analysis across items or at different points in time.

Question 4

Late Expansion Phase

Answer 4

Interest rates are typically rising as monetary policy becomes more restrictive, yield curve is expected to continue to flatten. Cyclical assets may underperform.

Question 5

Forecasting Challenges

Answer 5

Limitation to using economic data, time lag, revisions, rebased; data measurement errors, transcription error, survivorship, appraisal data; limitations of historic estimates, regime changes, non stationary data (different statistic properties with different time frames); using ex post to find ex ante risks; data mining with historical data; conditioning information, non constant statistic relationships; misinterpreting correlations; psychological biases; model uncertainty.

Question 6

Exogenous Shock

Answer 6

External from modelling and is a shock, they are not built in to market prices. Includes changes in government policy, political events, technological process, natural disasters, discovery of natural resources, financial crisis. Economic growth trends are effected.

Question 7

Trend Rate of Growth

Answer 7

DCF needs to keep the growth rate they use constant with the trend rate of economic growth. This rate is more stable in developed countries compared to emerging. The growth rate is forecasted on labour input (growth in labor force and labor participation), capital per worker, total factor productivity. Growth in labor force depends on population growth and demographics. Add all growth rates above together to get long term trend rate.

Question 8

Econometric Analysis

Answer 8

Structural and reduced form models are used. Can include many variables, can be reused once specified, output is quantified and based on relationships. Complex and time consuming, difficult if relationships change, does not work well to forecast turning points.

Question 9

Economic Indicators

Answer 9

Simple, intuitive, and easy in interpret. Readily available data from third parties. Indicator list can be tailored. Forecasting can be inconsistent, can give false signals, are revised frequently which can make them appear to fit past data when at the time they didn’t.

Question 10

Checklist Approach

Answer 10

More subjective with judgment required to interpret different factors. Less complex and more flexible to mix with objective statistical analysis to judge changing relationships. Time consuming and complexity must be limited.

Question 11

Business Cycle Phases: Initial Recovery

Answer 11

Govt stimulus through low interest rates or budget deficits. Decelerating inflation. Large output gap. Low or falling short term rates. Long term rates bottoming and bond prices peaking. Rising stock prices. Cyclicals doing well.

Question 12

Business Cycle Phases: Early Expansion

Answer 12

Increasing growth with low inflation (sales increasing but costs not catching up). Rising stock prices. Long term rates (bond yields) bottoming (stable) or increasing with bond prices beginning to decline. Rising short term rates.

Question 13

Business Cycle Phases: Late Expansion

Answer 13

High confidence and employment. Output gap eliminated and economy overheating. Increasing inflation. Central banks limiting growth in money supply. Rising short term rates. Rising long term rates. Bond prices declining. Stock prices peaking and volatile (costs catching up).

Question 14

Business Cycle Phases: Slowdown

Answer 14

Declining confidence. Inflation still rising. Short term rates at a peak. Long term rates at a peak and possibly falling, resulting in rising bond prices. Possible inverting yield curve. Falling stock prices.

Question 15

Business Cycle Phases: Contraction

Answer 15

Declining confidence and profits. Increase unemployment and bankruptcies. Inflation toping out. Falling short term and long term rates with bond prices increasing. Stock prices increasing during the later stages, anticipating the end of the recession.

Question 16

Inflation Within Expectations

Answer 16

Cash Equivalents: earn the real rate of interest.
Bonds: shorter term yields more volatile than longer term.
Equity: no impact given predictable economic growth
Real estate: neutral impact with typical returns

Question 17

Inflation Above or Below Expectations

Answer 17

Cash equivalents: positive when increasing
Bonds: longer term yields more volatile than short term
Equity: negative given potential central bank action or falling asset prices.
Real estate: positive as real assets increase with inflation

Question 18

Deflation

Answer 18

Cash equivalents: positive if nominal rates are bound by zero
Bonds: positive as future cash flows have greater purchasing power (assuming no default)
Equity: negative as economic activity and business declines
Real estate: negative as property values generally decline (worse if debt financed due to negative equity possibility which causes more selling)

Question 19

Taylor Rule

Answer 19

Equation in book, but controls for GDP and inflation to determine the target short term interest rate for the central bank.

Question 20

Fiscal Policy

Answer 20

Note that fiscal policy is only expansionary if the government is actively increasing spending. Natural forces like increased tax payments in an expansion or decrease in disbursement to the unemployed occur and are not considered expansionary policy.

Question 21

Monetary & Fiscal

Answer 21

Both stimulative, the yield curve is steep and economy is likely to grow in future. Both restrictive, yield curve is inverted and economy is likely to contract in future. Monetary restrictive and fiscal stimulative, yield curve is flat and implication on economy are less clear. Monetary is stimulative and fiscal policy is restrictive, yield curve is flat (or slightly upward sloping) and implications for the economy are not clear. Curve steep at beginning of cycle then flattens to inverts at top. Steepens again in contraction.

Question 22

FX Pegging

Answer 22

Linkage between the two countries business cycles will increase as pegged country follows economic policies of the other. Pegged country’s interest rates are typically higher than other the country’s to compensate for chance of peg failing. High confidence = small differential.

Question 23

High Yield Bonds

Answer 23

As a recovery begins, bond yields should bottom out and concerns about default should diminish. Both factors will lead to high-yield bonds performing well. A contraction will lead to concerns about default, and bond yields tend to rise in early expansion — both of these factors will limit the return to high yield bonds.