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Chapter 11 - Economic growth and the investment decision. This chapter describe and compare factors favoring and limiting economic growth in developed and developing economies, describe the relationship between the long-run rate of stock market appreciation and the sustainable growth rate of the economy, explain the importance of potential gross domestic product (GDP) and its growth rate in the investment decisions of equity and fixed-income investors,...
Chapter 11 economic Growth and the Investment Decision Presenter’s name Presenter’s title dd Month yyyy Introduction • Measuring and forecasting growth and the factors that contribute to growth are important in valuation and portfolio management • Forecasting growth requires understanding the drivers to an economy’s growth • The focus of economic growth is on the long-term trend in aggregate output Copyright © 2014 CFA 2 Growth in the Global Economy: Developed vs Developing countries Copyright © 2014 CFA Growth in the Global Economy: Developed vs Developing countries Factor Limiting Growth Favoring Growth Rate of savings and investment Low rate High rate Financial markets Poorly developed Well developed Legal system Corrupt or weak Well developed Property rights Lacking Well defined Education and health services Poor Good Policies regarding entrepreneurship High tax and restrictive regulations Low tax and few regulations International trade and flow of capital Restrictive Open Copyright © 2014 CFA Real GDP growth Copyright © 2014 CFA Why potential growth matters to investors Copyright © 2014 CFA Relevance to fixed-income investors Potential growth rate in GDP is important for fixed-income investors because it • affects economic forecasts of growth • is used to gauge inflationary pressures • is used to forecast real interest rate • influences rate of GDP growth on credit quality • affects monetary policy because the deviation between actual and potential GDP (the output gap) is a measure of resource utilization in the economy • affects the perceived risk of sovereign debt affects fiscal policy Copyright â 2014 CFA Determinants of economic growth The Cobb–Douglas production function is F(K, L) = KαL1 – α (11-2) which means that the output (the quantity produced) is a function of the inputs — capital (K) and labor (L) — and the marginal product of capital is the ratio of capital income to output (that is, GDP) Constant returns to scale (increasing input → increases output) Diminishing marginal productivity for each input Copyright © 2014 CFA Capital deepening and TFP • Total factor productivity (TFP) is the level of productivity or technology in an economy - • Technological progress is the improvement in technology, and an improvement in technology shifts the entire production function Capital deepening is an increase in the capital-to-labor ratio - It will increase output, but sustained economic growth cannot occur with capital deepening alone Output per Worker Increase in TFP g Capital deepenin Capital per Worker Copyright © 2014 CFA Growth Accounting ∆Y/Y Growth rate of output = ∆A/A Rate of technological change Copyright © 2014 CFA + α ∆K/K Growth rate of capital + (1 – α) ∆L/L Growth rate of labor 10 Labor force participation and growth • • The labor force participation rate is the percentage of working age population in the labor force - An increase in this rate may raise per capita GDP - Recent increases in this rate reflect the increased participation of women in the labor force - When comparing countries, demographics (e.g., age, gender) explains some of the differences in this rate - Immigration may offset the declining birthrates in developed countries - Countries may encourage or discourage immigration The growth rate of labor productivity affects a country’s sustainable rate of economic growth Copyright © 2014 CFA 12 Factors influencing economic growth Economic growth is affected by Labor - The average hours worked per worker affects the contribution of labor to output - The quality of the labor force (that is, human capital) is a source of growth Capital stock - There is a positive relationship between investment in the physical stock and growth - Growth in capital stock alone will not sustain growth - Composition of the physical capital matters to growth Technology - Technology affects both human and physical capital Copyright © 2014 CFA 13 Theories of growth Copyright © 2014 CFA 14 Converge or not to converge? Convergence is the situation in which the per capita income of developing countries converge toward that of developed countries • • • • Absolute convergence: Per capita income of developing countries will equal that of developed countries Conditional convergence: Per capita income of developing countries will equal that of developed countries if they have the same rate of savings, population growth rate, and production function Club convergence: Middle and rich countries (“in the club”) converge on the richest countries’ per capita income, but those not in the club not Nonconvergence trap: Some countries (“not in the club”) fail to converge because of the lack of institutional reforms Convergence can take place through developing countries’ capital accumulation and capital deepening or by developing countries imitating or adopting the technology of advanced countries Copyright © 2014 CFA 15 Per capita income Copyright © 2014 CFA 16 Convergence and investment • • Convergence can take place - through capital accumulation and capital deepening or - by imitating or adopting the technology of advanced countries Developing countries can grow faster (and achieve convergence) if they adopt or develop new technologies - • Therefore, spending on research and development assists convergence Prediction: Inverse relationship between initial level of per capita real GDP and the growth rate in per capita GDP Copyright © 2014 CFA 17 Relationship between Growth and income China France US Kenya Venezuela Copyright © 2014 CFA 18 Growth in an open economy Opening an economy affects the growth of the economy because investment is not constrained by domestic savings countries can shift resources to those goods and services for which they have a comparable advantage access to the global market for selling goods and services allows for economies of scale countries can import technology global trading increases competition in the local market Copyright © 2014 CFA 19 Dynamic adjustment process for Developing countries Copyright © 2014 CFA 20 Conclusions and Summary • • The sustainable rate of economic growth is measured by the rate of increase in the economy’s productive capacity or potential GDP Growth in real GDP measures how rapidly the total economy is expanding Per capita GDP measures the standard of living in each country - • • The growth rate of real GDP and the level of per capita real GDP vary widely among countries Equity markets respond to anticipated growth in earnings Higher sustainable economic growth should lead to higher earnings growth and equity market valuation ratios, all else being equal The best estimate for the long-term growth in earnings for a given country is the estimate of the growth rate in potential GDP - The growth rate of earnings cannot exceed the growth in potential GDP in the long run For global fixed-income investors, a critical macroeconomic variable is the rate of inflation Copyright â 2014 CFA 21 Conclusions and Summary • • • • One of the best indicators of short- to intermediate-term inflation trends is the difference between the growth rate of actual and potential GDP Capital deepening occurs when the growth rate of capital (net investment) exceeds the growth rate of labor An increase in total factor productivity causes a proportional upward shift in the entire production function One method of measuring sustainable growth estimates the growth rate of potential GDP by estimating the growth rates of the economy’s capital and labor inputs, plus an estimate of total factor productivity - An alternative method measures potential growth as the long-term growth rate of the labor force plus the long-term growth rate of labor productivity Copyright © 2014 CFA 22 Conclusions and Summary • • • • • • The forces driving economic growth include the quantity and quality of labor and the supply of capital, raw material, and technological knowledge The labor supply is determined by population growth, the labor force participation rate, and net immigration The physical capital stock in a country increases with net investment The correlation between long-run economic growth and the rate of investment is high Technology is a major factor determining total factor productivity, and total factor productivity is the main factor affecting long-term, sustainable economic growth rates in developed countries Once the weighted contributions of all explicit factors (e.g., labor and capital) are accounted for, total factor productivity is the residual component of growth Copyright © 2014 CFA 23 Conclusions and Summary • • Growth in labor productivity depends on capital deepening and technological progress Three important theories on growth are the classical, neoclassical, and new endogenous growth models - In the classical model, growth in per capita income is only temporary because an exploding population with limited resources brings per capita income growth to an end - In the neoclassical model, a sustained increase in investment increases the economy’s growth rate only in the short run, so long-run growth depends solely on population growth, progress in total factor productivity, and labor’s share of income - The neoclassical model assumes that the production function exhibits diminishing marginal productivity with respect to any individual input Copyright © 2014 CFA 24 Conclusions and Summary • • The main criticism of the neoclassical model is that it provides no quantifiable prediction of the rate or form of total factor productivity change; total factor productivity progress is exogenous to the model Endogenous growth theory explains technological progress within the model rather than treating it as exogenous As a result, self-sustaining growth emerges as a natural consequence of the model and the economy does not converge to a steady state rate of growth that is independent of saving/investment decisions - Unlike the neoclassical model, the endogenous growth model allows for the possibility of constant or even increasing returns to capital in the aggregate economy - In the endogenous growth model, expenditures made on R&D and for human capital may have large positive externalities or spillover effects Private spending by companies on knowledge capital generates benefits to the economy as a whole that exceed the private benefit to the company Copyright © 2014 CFA 25 Conclusions and Summary • The convergence hypothesis predicts that the rates of growth of productivity and GDP should be higher in the developing countries Those higher growth rates imply that the per capita GDP gap between developing and developed economies should narrow over time - The evidence on convergence is mixed - Countries fail to converge because of low rates of investment and savings, lack of property rights, political instability, poor education and health, restrictions on trade, and tax and regulatory policies that discourage work and investing - Opening an economy to financial and trade flows has a major impact on economic growth The evidence suggests that more open and trade-oriented economies will grow at a faster rate Copyright © 2014 CFA 26 ... in the labor force - An increase in this rate may raise per capita GDP - Recent increases in this rate reflect the increased participation of women in the labor force - When comparing countries,... is, GDP) Constant returns to scale (increasing input → increases output) Diminishing marginal productivity for each input Copyright © 2014 CFA Capital deepening and TFP • Total factor productivity... earnings for a given country is the estimate of the growth rate in potential GDP - The growth rate of earnings cannot exceed the growth in potential GDP in the long run For global fixed-income investors,