Capital Market Expectations INTRODUCTION Capital market expectations (CME) (also known as macro expectations) represent the investors’ expectations regarding the risk and return prospects of broad asset classes They help investors in formulating their strategic asset allocation, that is, in setting rational return expectations on a long term basis for globally diversified portfolios 2.1 By contrast, micro expectations represent the investors’ expectations regarding the risk and return prospects of individual assets They facilitate investors in security selection and valuation ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES A Framework for Developing Capital Market Expectations A framework for developing Capital market expectations has the following seven steps Specify the final set of expectations that are needed, including the investment time horizon: This step involves clearly specifying the questions that need to be answered • An investor/analyst must determine the specific objectives of the analysis E.g for a taxable investor, the objective is to develop long-term after-tax capital market expectations • An investor/analyst must specify the relevant set of asset classes (consistent with the investment constraints) on which the investor/analyst needs to develop capital market expectations • It is important to understand that the scope of the capital market expectations-setting framework is directly related with the number and variety of permissible asset class alternatives i.e the greater the number and variety of permissible asset classes, the wider the scope of setting capital market expectations Refer to Example on page NOTE: If the number of asset classes is n, the analyst will need to estimate: • n number of expected returns; • n number of standard deviations; • (n2 – n) / distinct correlations (or the same number of distinct covariances); Research the historical record: Historical data provide some useful information on the investment characteristics of the asset Hence, the historical performance of the asset classes should be analyzed in order to identify their return drivers Analyzing each asset class’s historical performance involves gathering macroeconomic and market information in different ways e.g., by: • Geographical area (e.g., domestic, nondomestic, or some subset e.g a single international area); or • Broad asset class (e.g equity, fixed-income, or real estate); or • Economic sector/industry/sub-industry basis; The historical data can be used as a baseline and may be adjusted for analyst’s views e.g if an analyst is optimistic (pessimistic) relative to the consensus on the prospects for asset class A, then he/she may make an upward (downward) adjustment to the historical mean return Specify the method(s) and/or model(s) that will be used to formulate CME and the information required to develop such models: • The analyst should clearly specify the method(s) and/or model(s) that will be used to develop CME • The method(s) and/or model(s) used must be consistent with the objectives of the analysis and investment time horizon e.g a DCF method is most appropriate to use for developing long-term equity market forecasts Determine the best sources for the information needed: The analysts/investors should search for the best and most relevant sources for the information needed and should be constantly aware of new, superior sources for their data needs It involves considering following factors: • Data collection principles and definitions; • Error rates in collection and calculation formulas; • Quality of asset class indices (i.e Investability, correction for free float, turnover in index constituents); • Biases in the data; • Costs of data etc; In addition, the analysts must select the appropriate data frequency e.g long-term data series should be used for setting long-term expectations or evaluating long-term volatility In general, • For setting long-term CME, quarterly or annual data series are useful –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 14 Reading 14 Capital Market Expectations • For setting shorter-term CME, daily data series are useful Interpret the current investment environment: The analyst should interpret the current investment environment using the selected data and methods and should employ consistent set of assumptions Also, he should apply experience and judgment (where necessary to interpret any conflicting information within the data) so that the conclusions are mutually consistent Provide the set of expectations that are needed and document conclusions: This step involves documenting answers to the questions formulated in step In addition to answers and conclusions, the analyst should also document reasoning and assumptions associated with the conclusion The set of expectations obtained in step are then used to develop forward-looking forecasts on capital markets Monitor actual outcomes to provide feedback to improve the CME development process: This step involves monitoring and comparing actual outcomes against expected outcomes to identify weaknesses in the CME development process so that the expectations-setting process or methods can be improved Beta versus Alpha Research: Beta Research: Beta research involves developing capital market expectations concerning the systematic risk and returns to systematic risk Unlike alpha research, beta research is centralized which implies that CME inputs used across all equity and fixed-income products are consistent Alpha Research: Alpha research involves developing expectations regarding individual assets in an attempt to capture excess risk-adjusting returns by a particular investment strategy Three Characteristics of Good Forecasts: Good forecasts are 1) Unbiased, objective, and well researched; 2) Efficient i.e has minimum forecasting errors; 3) Internally consistent i.e if asset class A and B are perfectly negatively correlated and asset class B and C are also perfectly negatively correlated, then asset class A and C must be perfectly positively correlated Practice: Example & 5, Volume 3, Reading 14 2.2 FinQuiz.com Challenges in Forecasting (section 2.2.1 - 2.2.9) The data and assumptions used in the forecasting model must be error free The challenges associated with forecasting include: 1) Limitations of Economic Data: • Definitions and calculation methods may change over time This may affect the validity of time-series data • Errors in collection and measurements of data and in the calculation formulas; • Timeliness of data i.e time lag with which economic data are collected, processed, and disseminated For example, the International Monetary Fund sometimes provides macroeconomic data for developing economies with a lag of two years or more o The greater the lag before information is reported (i.e the older the data), the greater the risk that it provides irrelevant and uncertain information about the present situation • Changes in the construction method of data: The bases of indices of economic and financial data are changed on a periodic basis to reflect more current bases This process is known as re-basing Re-basing simply reflects a mathematical change rather than substantive change in the composition of an index Re-basing may result in risk of mixing data indexed to different bases 2) Data Measurement Errors and Biases: The errors and biases in data measurement include: Transcription errors: The errors relating to gathering and recording of data are called transcription errors Transcription errors are most serious when they reflect bias Survivorship bias: Survivorship bias occurs when a data series reflects data on surviving (or successful) entities and not reflect post-delisting data (e.g data on entities with poor performance which have been removed from the database) This bias results in overestimated historical returns Appraisal (smoothed) data: Infrequently traded and illiquid assets (e.g real estate, private equity etc) not tend to have up-to-date market prices; rather, their values need to be estimated, known as appraised values Appraised values (i.e smoothed data) represent less volatile values As a result, the correlations of such assets with traditional assets (i.e equities and fixed income) and risk (S.D.) of assets are underestimated or biased downward • Remedy to mitigate smoothing effect: The smoothed data bias can be mitigated by rescaling the data so that their dispersion (i.e S.D.) is increased but the mean of the data is unchanged Reading 14 Capital Market Expectations 3) The Limitations of Historical Estimates: The simplest approach to forecasting is to use historical data to directly forecast future outcomes However, the historical estimates may not be good predictors of future results because the risk/return characteristics of asset classes may change as a result of changes in technological, political, legal and regulatory environments and disruptions i.e war or natural disaster These so called regime changes introduce the statistical problem of non-stationarity (where different parts of a data series exhibit different underlying statistical properties) In addition, the disruptions in a certain time period may temporarily increase volatilities in that period which may not be relevant for the future period • Although use of long time series data increases the precision* of estimates of population parameters and reduces the sensitivity of parameter estimates to the starting and ending dates of the sample; however, using long time series (reflecting multiple regimes) may increase the risk of non-stationarity in the data (due to structural changes during the time frame) and consequently, the risk of including irrelevant data • In addition, for some time-series analysis, the data series of the required length may not be available Using high-frequency data (weekly or even daily) in order to get data series of required length increases risk of asynchronism (i.e discrepancy in the dating of observations due to use of stale/out-of-date data) and results in underestimated correlations estimates *Precision of the estimate of the population mean is proportional to / √number of observations 4) Ex Post Risk Can Be a Biased Measure of Ex Ante Risk: In general, the ex-ante risk and ex-ante return are underestimated on backward-looking basis Hence, ex-post risk estimates may be a poor proxy of the ex ante risk estimate The investment decision-making must be based on ex-ante risk measures rather than ex-post risk measures 5) Biases in Analysts’ Methods Data-mining bias: Data mining bias refers to over-using or overanalyzing the same or related data (i.e mining the data) until some statistically significant pattern is found in the dataset Two signs that may indicate the existence of data-mining bias include: i Many of the variables used in the research are not reported; ii No plausible economic relationship exists among variables; The data mining bias can be detected by using out-ofsample data to test the statistical significance of the patterns found in the dataset Time-period bias: Time-period bias occurs when outcomes/results are time-period specific For example, FinQuiz.com a short time series may give period-specific results that may not reflect a longer time period Similarly, test based on long time period may suffer from structural changes occurring during the time frame, resulting in two data sets with different relationships As a result, forecasted relationship estimated from the first period may not hold for second sub-period 6) The Failure to Account for Conditioning Information may lead to misperceptions of risk, return, and riskadjusted return: Future risk and return of an asset as of today depend or are conditional upon on specific characteristics of the current marketplace and prospects looking forward Hence, the expectations concerning future risk and return of an asset must take into account any new, relevant information in the present For example, since systematic risk of an asset class varies with business cycle, the expectations concerning systematic risk of an asset class should be conditioned upon the state of the economy EXAMPLE Suppose, • Beta of an asset class in economic expansions = 0.80 • Beta of an asset class in economic recessions = 1.2 • Expected return on market during expansion = 12% • Expected return on market during recession = 4% • Risk-free rate (both recession & expansion) = 2% Unconditional beta = 0.50 (0.80) + 0.50 (1.2) = 1.0 Unconditional risk-free rate = 0.50 (2%) + 0.50 (2%) = 2% Unconditional expected return on market = 0.50 (12%) + 0.5 (4%) = 8% Unconditional expected return on asset class i (using CAPM) = 2% + 1.0 (8% - 2%) = 8% Expected return on market during expansion (using CAPM) = 2% + 0.80 (12% - 2%) = 10% Expected return on market during recession (using CAPM) = 2% + 1.20 (4% - 2%) = 4.4% Conditional expected return on market = 0.50 (10%) + 0.50 (4.4%) = 7.2% Unconditional alpha = 7.2% - 8% = -0.8% Alpha during expansion and recession = 0.50 (0%) + 0.50 (0%) = 0% 7) Misinterpretation of Correlations: A significantly high correlation between variable A and B implies one of the following things: • Variable A is predicted by variable B i.e variable B is exogenous variable (which is determined outside the system) and variable A is endogenous variable (which is determined within the system) • Variable B is predicted by variable A i.e variable A is exogenous variable and variable B is endogenous variable • Neither variable A predicts B nor B predicts A; rather, a third variable C predicts A and B the variable C is referred to as a control variable Reading 14 Capital Market Expectations The impact of multiple control variables can be analyzed using multiple-regression analysis Multiple-regression analysis A = β0 + β1 B + β2 C + ε • The coefficient β1 represents the partial correlation between A and B i.e the effect of variable B on variable A after taking into account the effect of the control variable C on A • The coefficient β2 represents the partial correlation between A and C i.e the effect of variable C on variable A after taking into account the effect of variable B on A • When estimated value of β1 is significantly different from but β2 is not significantly different from 0, it indicates that variable B predicts variable A Time series analysis A = β0 + β1 Lagged values of A + β2 Lagged values of B + β2 Lagged values of C + ε FinQuiz.com c) The confirming evidence trap: It is a tendency of people to seek and focus on information that confirms their beliefs or hypothesis and ignore, reject or discount information that contradicts their beliefs Confirmation bias implies assigning greater weight to information that supports one’s beliefs This bias can be reduced or mitigated by: • Collecting and examining complete information i.e both positive and negative • Actively looking for contradictory information and contra-arguments • Being honest with one’s motives and investment objectives d) The overconfidence trap: It is a tendency of people to overestimate their knowledge levels and their ability to process and access information In this bias, people tend to believe that they have superior knowledge and they make precise and accurate forecasts than it really is NOTE: It must be stressed that two variables may reflect low or zero correlation despite strong but non-linear relationship because correlation measure ignores non-linear relationships 8) Psychological Traps Psychological traps can undermine the analyst’s ability to make accurate and unbiased forecasts a) The anchoring trap: It is a tendency of people to develop estimates for different categories based on a particular and often irrelevant value (both quantitative & qualitative), called anchor (i.e a target price, the purchase price of a stock, prior beliefs on economic states of countries or on companies etc) and then adjusting their final decisions up or down based on that “anchor” value • Anchoring bias implies investor under-reaction to new information and assigning greater weight to the anchor • Anchoring bias can be mitigated by avoiding premature conclusions b) The status quo trap: It is a tendency of people to prefer to “do nothing” (i.e maintain the “status quo”) instead of making a change In the status-quo bias, investors prefer to hold the existing investments in their portfolios even if currently they are not consistent with their risk/return objectives • It is closely related with avoiding “Error of commission” (i.e regret from an action taken) and “Error of omission” (i.e regret from not taking an action) • The status-quo trap can be overcome by following a rational analysis in investment decision-making • The overconfidence trap may result in using too narrow range of possibilities or scenarios in forecasting • The overconfidence trap can be avoided by widening the range of possibilities around the primary target forecast e) The prudence trap: It is the tendency of analysts to be extremely cautious in forecasting in an attempt to avoid making any extreme forecasts which may adversely impact their career As a result, they make forecast estimates that are in line with other analysts (representing herding behavior) • The prudence trap can be avoided by widening the range of possibilities around the target forecast f) The recallability trap: It is the tendency of analysts to assign higher weight to more easily available and easily recalled information e.g information related to catastrophic or dramatic past events This bias can be avoided by using objective data and procedures in decision-making Practice: Example 11, Volume 3, Reading 14 9) Model Uncertainty: Investment analysis may be subject to two kinds of uncertainty i.e i Model uncertainty is the uncertainty related to the accuracy of the model selected The model uncertainty can be evaluated by analyzing the variation in outcomes of the models from shifting between the several most promising models Reading 14 Capital Market Expectations ii Input uncertainty is the uncertainty related to the accuracy of inputs used in the model 3.1 Capital market anomalies (inefficiencies) often exist due to input and model uncertainty TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS Formal Tools (Section 3.1.1 – 3.1.4) Formal tools used for formulating capital market expectations include: I II III IV FinQuiz.com Statistical methods Discounted cash flow models The risk premium approach Financial market equilibrium models Statistical Methods: There are two major types of Statistical methods • Descriptive Statistics: Statistical Methods that are used to organize and summarize data so that important aspects of a dataset can be described are known as descriptive statistics • Inferential Statistics: Statistical Methods that are used to make estimates or forecasts about a larger group (population) based upon information taken from a smaller group (sample) are known as inferential statistics a) Historical Statistical Approach: Sample Estimators: In a historical statistical approach, historical data is used as the basis for forecasts • A sample estimator is a formula used to compute an estimate of a population parameter The value of that estimate (statistic) is called a point estimate • The point estimate is useful to estimate population parameter when the time series data is stationary • In a mean-variance framework, the analyst might use: o The sample arithmetic mean of total return or sample geometric mean of total return as an estimate of the expected return The arithmetic mean is appropriate to use to estimate the mean return in a single period whereas the geometric mean is appropriate to use to estimate mean return for multi-periods For a risky (volatile) variable, the geometric mean return will always be < the arithmetic mean return o The sample variance as an estimate of the variance; and o Sample correlation as an estimate of correlation b) Shrinkage Estimators: Shrinkage estimation is a process in which an estimate of a parameter is computed by taking weighted average of a historical estimate of a parameter and some other estimate of a parameter Shrinkage estimation is also known as the “two-estimates-are-better-than-one” approach Shrinkage Estimator = (Weight of historical estimate × Historical parameter estimate) + (Weight of Target parameter estimate × Target parameter estimate) For example, Shrinkage estimator of the covariance matrix = (Weight of historical covariance × Historical covariance) + (Weight of Target covariance × Target covariance) Where, Target parameter estimate = Alternative parameter estimate • The target covariance matrix can be a factormodel-based estimate or can be a covariance estimate based on the assumption that each pairwise covariance is equal to the overall average covariance • Weights reflect the analyst’s relative belief in the estimates e.g the more strongly an analyst believes in the historical estimate, the larger the weight of the historical estimate • The historical sample covariance matrix is not appropriate to use for small samples Hence, shrinkage estimation is a superior approach for estimating population parameter for the medium and smaller size because it helps to decrease (i.e shrink) the impact of extreme values in historical estimates and increases the efficiency of the parameter estimates The more plausible target estimate is selected, the greater the improvement in the accuracy of the estimate • The Shrinkage estimation method is commonly used for computing covariances and mean returns Example: Suppose • Using factor model, the estimated covariance between domestic shares and bonds = 40 • Using historical estimate, the estimated covariance between domestic shares and bonds = 75 • Weight of historical estimate = 0.30 • Weight of target estimate = 0.70 Shrinkage estimate of the covariance = 0.70 (40) + 0.30 (75) = 50.5 Reading 14 Capital Market Expectations Practice: Example 12, Volume 3, Reading 14 c) Time-Series Estimators: Time series estimation involves regressing the value of dependent variable on the lagged values of dependent variable and lagged values of other selected variables Time series estimation methods are useful to make short-term/ near-term forecasts for financial and economic variables They are also used to forecast near-term volatility, assuming variance clustering exists • Variance clustering: When large (small) fluctuations in prices are followed by large (small) fluctuations in prices in random direction, it is referred to as “Variance Clustering” σ2t = βσ2t-1 + (1 – β) ε2t Where, σ2t = Volatility in period t σ2t-1 = Volatility in previous period ε2t = a random “noise” term β = Weight on σ2t-1 Measure of rate of decay of the influence of the value of volatility in period t-1 on value of volatility in period t with ) 10-year Treasury bond yield The earnings yield is a conservative estimate of the expected return for equities because it is the required rate of return for no-growth equities For details, refer to Reading 18 3.1.2.2 Fixed-Income Markets Bonds are quoted in terms of a single discount rate, referred to as yield to maturity or YTM YTM is the discount rate that equates the present value of the bond’s promised cash flows to its market price • Typically, YTM of a reference fixed-income security (called bellwether) is used as a proxy for expected rate of return on the bond • YTM is a superior estimate for expected rate of return on the zero-coupon bond (i.e bond with no intermediate cash flows) because it assumes that as interest payments are received, they can be reinvested at an interest rate equal to YTM • For callable bonds, yield-to-worst is sometimes used as a conservative estimate of expected rate of return The Risk Premium Approach: In the risk premium approach, the expected return on a risky asset “i” is computed as follows E (Ri) = RF + (Risk premium)1 + (Risk premium)2 + …+ (Risk premium) K Where, E(Ri) = Asset’s expected return RF = Risk-free rate of interest NOTE: When assets are fairly priced, an asset’s required return = Investor’s expected return 3.1.3.2 Fixed-Income Premiums The expected bond return, E (Rb), can be estimated as follows: E(Rb) = Real risk-free interest rate + Inflation premium + Default risk premium + Illiquidity premium + Maturity premium + Tax premium FinQuiz.com Where, a) Real risk-free interest rate is the single-period interest rate for a completely risk-free security if no inflation were expected It represents the compensation demanded by investors for forgoing current consumption • The current real rate depends on cyclical factors • The long-term real rate depends on sustainable equilibrium conditions b) Inflation premium represents the compensation demanded by investors for risk associated with increase in inflation It is typically a more volatile component of bond yield Inflation premium = Average inflation rate expected over the maturity of the debt + Premium (or discount) for the probability attached to higher inflation than expected (or greater disinflation) Or Inflation premium = Yield of conventional government bonds (at a given maturity) – Yield on Inflation-indexed bonds of the same maturity • Inflation premium varies depending on base currency consumption baskets c) Default risk premium represents the compensation demanded by investors for the risk of default of the borrower Default risk premium = Expected default loss in yield terms + Premium for the nondiversifiable risk of default d) Illiquidity premium represents the compensation demanded by investors for the risk of loss associated with converting assets (particularly illiquid assets) into cash quickly The illiquidity premium is positively related to the illiquidity horizon e.g the longer the length of investment’s lock-up period for an alternative investment, the greater the illiquidity premium e) Maturity premium represents the compensation demanded by investors for higher interest rate risk associated with longer-maturity debt Maturity premium = Interest rate on longer-maturity, liquid Treasury debt - Interest rate on short-term Treasury debt f) A tax premium represents the compensation demanded by investors for assuming risk of lower after-tax return due to higher tax rates Reading 14 Capital Market Expectations 3.1.3.3 The Equity Risk Premium The equity risk premium is the compensation demanded by investors for assuming greater risk associated with equity relative to debt Equity risk premium = Expected return on equity (e.g expected return on the S&P 500) – YTM on a long-term government bond (e.g 10-year U.S Treasury bond return) Thus, Expected return on equity = YTM on a long-term government bond + Equity risk premium FinQuiz.com World market portfolio: The global investable market (GIM) can be used as a proxy for the world market portfolio GIM consists of traditional and alternative asset classes with sufficient capacity to absorb meaningful investment An asset class risk premium (RPi) = Sharpe ratio of the world market portfolio × Asset’s own volatility × Asset class’s correlation with the world market portfolio RPi = (RPM / σM) × σi × ρi,M Where, RPM = Expected excess return σM = Standard deviation of the world market portfolio represents systematic or nondiversifiable risk • It is known as Bond-yield-plus-risk-premium method Or ܴܲ = Financial Market Equilibrium Models Financial equilibrium models explain relationships between expected return and risk when financial market is in equilibrium (i.e where supply is equal to demand) Types of Financial Market Equilibrium Models: Black-Litterman approach: The Black-Litterman approach determines the equilibrium returns using a reverse optimization method i.e “reverse engineering” them from their market capitalization in relation to the market portfolio It then incorporates investor’s own views in determining asset allocations For example, in the absence of any investors’ views about a particular asset class, market implied returns are used because its equilibrium and optimal weights are identical The international CAPM-based approach (ICAPM): Under ICAPM, the Expected return on any asset = Domestic risk-free rate + Risk premium based on the asset’s sensitivity to the world market portfolio and expected return on the world market portfolio in excess of the risk-free rate Or E (Ri) = RF +βi [E (RM) – RF] Where, E(Ri) = The expected return on asset i given its beta RF = Domestic Risk-free rate of return E(RM) = the expected return on the world market portfolio βi = the asset’s sensitivity to returns on the world market portfolio, = Cov (Ri, RM) / Var (RM) Assumptions of ICAPM: Purchasing power parity relationship holds, implying that the risk premium on any currency equals zero ߚ ሺܴܲ ሻ = ሾܴ(ݒܥ , ܴெ )/ߪெଶ ሿሺܴܲெ ሻ = ቆ = ߪ ߩெ ൬ ܴܲெ ൰ ߪெ ߪ ߪெ ߩெ ቇ × ሺܴܲெ ሻ ߪெଶ • Commonly, 0.28 is used as an estimate of Sharpe ratio of the GIM • The Sharpe ratio of the global market may change with changes in global economic fundamentals The Singer-Terhaar Approach: The ICAPM assumes that markets are perfect and as a result ignores market imperfections By contrast, the Singer-Terhaar approach takes into account the market imperfections, including illiquidity and market segmentation • Market integration: International markets are integrated when there are no impediments or barriers to capital mobility across markets When markets are integrated, two identical assets with the same risk characteristics must have the same expected return across the markets Types of Barriers: a Legal barriers i.e restrictions placed by a national emerging market on foreign investment; b Cultural impediments; c Investor preferences; • Market segmentation: International markets are segmented when there are impediments to capital market movements When markets are segmented, two identical assets with the same risk characteristics may have different expected returns (i.e may trade at different exchange rate adjusted prices in different countries, violating the law of one price) o The more the market is segmented, the more it is dominated by local investors; • In practice, the asset markets are neither perfectly segmented nor perfectly integrated In other words, an asset market is partially segmented or integrated Reading 14 Capital Market Expectations In summary: Steps of estimating Expected Return using Singer-Terhaar Approach Separately estimate the risk premium for the asset class using the ICAPM under two cases i.e a perfectly integrated market and the completely segmented market Calculations: Step 1: Bond Risk premium under completely integrated markets = 8% × 0.45 × 0.28 = 1.008% Equity Risk premium under completely integrated markets = 16% × 0.65 × 0.28 = 2.912% Bond Risk premium under completely segmented markets = 8% ì 0.28 = 2.24% ã When a market is completely segmented, the reference market portfolio is the same as the individual local market Consequently, the ρi,M = Risk premium for a perfectly segmented market = RPi = RPM σm σ i × • The risk premium for a perfectly segmented market is greater than that for the perfectly integrated markets, all else equal • Note: For simplicity, it is assumed that the Sharpe ratio of the GIM is equal to the Sharpe ratio of the local market portfolio Add the applicable illiquidity premium, if any, to the ICAPM expected return estimates (from step 1) Estimate the degree of integration of the given asset market For example, it has been observed that developed market bonds & equities are approx 80% integrated and 20% segmented Estimate the risk premium assuming partial segmentation by taking a weighted average of risk premium under perfectly integrated markets and risk premium under perfectly segmented markets The weights represent degree of integration of the given asset market (from step 3) Risk premium of the asset class, assuming partial segmentation = (Degree of integration × Risk premium under perfectly integrated markets) + ({1 - Degree of integration} × Risk premium under perfectly segmented markets) Estimate the expected return on the asset class by adding the risk premium estimate (from step 4) to the risk-free rate yields Example: FinQuiz.com Equity Risk premium under completely segmented markets = 16% × 0.28 = 4.48% Step 2: Since there is no illiquidity premium, the bond and equity risk premium will remain the same as calculated in step Step 3: The degree of integration is estimated to be 80% or 0.80 Step 4: Final risk premium estimates are as follows Risk Premium (fixed income) = (0.80 × 1.008%) + (0.20 × 2.24%) = 1.2544% Risk Premium (equities) = (0.80 × 2.912%) + (0.20 × 4.48%) = 3.2256% Step 5: Expected return on bonds or equities = Risk-free rate + relevant risk premium Expected return on bonds = 5% + 1.2544% = 6.2544% Expected return on equities = 5% + 3.2256% = 8.2256% Estimating the amount of illiquidity premium: The amount of illiquidity premium of an asset can be estimated using investment’s multi-period Sharpe ratio (MPSR) MPSR reflects investment’s multi-period return in excess of the return generated by the risk-free investment adjusted for risk The MPSR must be calculated over the holding period equal to lock-up period of investment Rule: The investor should invest in illiquid investment if it’s MPSR at the end of the lockup period ≥ MPSR of the market portfolio Illiquidity premium = Expected return of an illiquid asset – Required rate of return on an illiquid asset at which its Sharpe ratio is equal to that of market’s Sharpe ratio Suppose • • • • • • S.D of Canadian bonds = 8% S.D of Canadian equities = 16% Correlation of Canadian bonds with GIM = 0.45 Correlation of Canadian equities with GIM = 0.65 Risk-free rate = 5% Illiquidity premium = Covariance between any two assets = Asset beta × Asset beta × Variance of the market Where, Beta of asset = σ × ρ (1, m) σ m Beta of asset = σ × ρ (2, m) σm Reading 14 Capital Market Expectations output from such surveys largely depends on the professional identity of the respondent Practice: Example 18 &19, Volume 3, Reading 14 3.3 3.2 Survey and Panel Methods In the Survey method of capital market expectations setting, the analysts inquire a group of experts for their expectations and then use their responses in formulating capital market expectations When a group of experts provide fairly stable responses, the group is referred to as a panel of experts and the method is called a panel method The limitation of survey method is that the Judgment In a disciplined expectations-setting process, all the assumptions and rationales used in the analysis must be explicitly documented by an analyst In addition, the analyst must explicitly mention the judgments used in the analysis in an attempt to improve forecasts The process of applying judgment can be formalized using a set of devices e.g checklists ECONOMIC ANALYSIS According to the Asset-pricing theory, the risk premium of an asset is positively correlated with its expected payoffs in a given economic condition For example, assets with high expected payoffs during periods of weak consumption (business cycle troughs) tend to have lower risk premiums (implying higher prices) compared to assets with low expected payoffs during such periods An analyst who has greater ability to predict a change in trend or point of inflection in economy activity and who has the ability to identify economic variables relevant to the current economic environment is considered to have a competitive advantage The inflection points are indicators of both unique investment opportunities and source of latent risk Two major Components of Economic Growth: 1) Trend Growth: It identifies the long-term component of growth in an economy It is relevant for setting longterm return expectations for asset classes 2) Cyclical Growth: It measures short-term fluctuations in an economy Cyclical variation affects such variables as corporate profits and interest rates etc 4.1 FinQuiz.com Business Cycle Analysis There are two types of cycles associated with business cycle analysis: 1) Short-term inventory cycle: This cycle typically lasts for 2-4 years 2) Longer-term business cycle: This cycle typically lasts for 9-11 years • It is important to note that the duration and amplitude of each phase of the cycle, as well as the duration of the cycle as a whole are sensitive to major shocks in the economy (i.e wars, petroleum or financial crisis, and shifts in government policy) and vary considerably; hence, they are difficult to forecast The economic activity can be measured using the following measures: Gross domestic product (GDP): GDP represents the total value of final goods and services produced in the economy during a given year GDP (using expenditure approach) =Consumption + Investment + Change in Inventories + Government spending + (Exports - Imports) • Economists prefer to focus on Real GDP (i.e increase in the value of GDP adjusted for changes in prices) because it reflects the change in the standard of living The higher the real GDP, the greater the standard of living Output gap: Output Gap = Potential value of GDP (i.e potential output achieved if economy follows its trend growth) – Actual value of GDP • The output gap is positive (i.e potential GDP > actual GDP) during period of economic recession or slow growth Inflation tends to fall when output gap is positive • The output gap is negative (i.e potential GDP < actual GDP) during period of economic expansion or fast growth Inflation tends to rise when output gap is negative o When actual GDP growth rate > trend rate, it may not give signs of overheating economy provided that unemployment is relatively high and there is spare capacity in the economy It is important to understand that real time estimates of output gap may not necessarily always be accurate because economy’s trend path is affected by changes in demographics and technology Reading 14 Capital Market Expectations Recession: A recession refers to a broad-based economic downturn i.e when an economy faces two successive quarterly declines in GDP 4.1.1) The Inventory Cycle The inventory cycle is a cycle that identifies fluctuations in inventories The inventory cycle results from adjusting inventories at desired levels in response to changes in expected level of sales Phases of Inventory Cycle: A Up phase: Future sales are expected to increase leading to increase in production in an attempt to increase inventories overtime pay and employment increases to meet increasing production needs as a result, economy boosts and sales further increase B Down phase: After reaching some peak point (referred to as inflection point), sales start falling and/or future sales are expected to fall (e.g due to tight monetary policy, higher oil prices etc.) Consequently, production is cut back and inventory level decreases Due to reduction in production layoffs, increase and/or hiring process slows down As a result, economy slows down and sales further decrease • Generally, after an inflection point, the inventory levels are adjusted to their desired levels within a period of year or two Indicator of Inventory Position: The inventory position can be gauged using “Inventory/sales ratio” It is interpreted as follows: • Falling inventory/sales ratio indicates that in the near future, businesses will try to rebuild inventory; as a result, economy is expected to strengthen in the next few years • Sharply rising inventory/sales ratio indicates that in the near future, businesses will try to reduce inventory; as a result, economy is expected to weaken in the next few years It is important to understand that due to improved techniques, i.e “just-in-time” inventory management, inventory/sales ratio has been trending down 4.1.2) The Business Cycle The business cycle represents short-run fluctuations in GDP (i.e level of economic activity) around its long-term trend growth path A typical business cycle is comprised of the following five phases: Initial Recovery: The economy starts to grow from its slowdown or recession This phase lasts for few months • Confidence among businesses starts to increase; • Unemployment is still high → thus, consumer FinQuiz.com confidence is at low levels; • Inflation falls; • Output gap is still large & there is spare capacity; • The recovery largely results from the simultaneous upswing in the inventory cycle; Economic Policies: • Stimulatory monetary policy i.e interest rates fall; • Stimulatory fiscal policy i.e budgetary deficit grows; Capital Market Effects: • Government bond yields continue to fall in expectation of falling inflation and then start bottoming; • Stock markets may perform well (i.e stock prices rise); Attractive Investments: • Cyclical assets • Riskier assets i.e small stocks, higher-yield corporate bonds, emerging market equities & bonds; Early Upswing: The economy starts gaining momentum This phase is considered to be the healthiest period of the cycle because of the absence of any inflationary pressure in the economy This phase usually lasts for at least a year and often several years provided that growth is not too strong and the output gap closes slowly • Confidence among businesses is increasing; • Unemployment starts to fall as more workers are hired in response to increased production & higher demand → consumer confidence starts rising → as a result, consumers borrow more and spending increases; • Inflation falls; • Output gap is still large & there is spare capacity; • The recovery largely results from the simultaneous upswing in the inventory cycle; • Inventory levels build up in anticipation of future increase in sales; • Capacity utilization increases → per unit cost falls → profits rise rapidly; Economic Policies: • Central bank starts withdrawing stimulatory monetary & fiscal policies introduced during recession; Capital Market Effects: • Short-term interest rates start rising; • Longer-term bond yields may be stable or increase slightly; • Stock markets are rising; Reading 14 Capital Market Expectations Late Upswing: During this phase, an economy tends to grow rapidly and is likely to be overheated and face inflationary pressures due to closing of output gap • Confidence among businesses & consumers is still rising; • Unemployment is low (i.e economy is at or near full employment); • Due to shortages of labor supply → wages rise → consequently, production costs & inflation starts to accelerate; Economic Policies: • Restrictive monetary policy i.e interest rates increase; • However, the policy is not severly restrictive as it aims to cool down the economy rather than pushing economy into downturn; (known as "soft landing") Capital Market Effects: • Interest rates tend to rise due to heavy borrowing by consumers & businesses; • Bond yields also tend to rise; o →Due to rising bond yields, bondholders incur capital losses • Stock markets may rise because higher inflation should be reflected in higher profits; o but it is highly volatile, depending on the strength of boom because investors fear that inflation may be moving out of equilibrium Slowdown: The economy starts slowing down primarily due to rising interest rates During this phase, an economy is highly in danger of going into recession It lasts just a few months, or it may last a year or more • Confidence among businesses starts falling; • Unemployment is still high → thus, consumer confidence is at low levels & demand falls; • Inflation is still rising despite slowdown in growth; • Inventory levels are reduced due to cut back in production; Capital Market Effects: • Short-term interest rates are high & rising; • But, after reaching some peak point, they start falling → indicating inverted yield curve; • As the yields fall afterwards, bonds rally sharply; • Stock markets may perform poorly as higher interest rates will lead to slowing economic growth, resulting in lower sales, revenues and profits; In addition, as interest rates rise, the return on alternative investments increases and stocks become less attractive; FinQuiz.com Attractive Investments: • Interest-sensitive stocks i.e utilities and financial services; Recession: Recession is associated with two successive quarterly declines in GDP This phase typically lasts for months to a year • Businesses & consumers confidence decline significantly; • Profits fall sharply; • Production declines and inventory levels are reduced considerably; • Business investment falls; • Consumer spending on luxury goods (i.e car) fall; • Unemployment rises sharply; • Inflation starts to fall; • Often associated with major bankruptcies, incidents of uncovered fraud, or a financial crisis; as a result, lenders are reluctant to lend Economic Policies: • Stimulatory monetary policy i.e interest rates fall; however, very marginally initially; Capital Market Effects: • Both Short-term interest rates & longer-term bond yields start falling; • Stock markets start to improve in the later stages of the recession; Attractive Investments: • Bonds generate capital gains ; • But, deteriorating credit quality may offset such gains for some bonds; The Yield Curve, Recessions, and Bond Maturity: The yield spread between the 10-year T-bond rate and the 3-month T-bill rate indicates expected future growth in output • Positive or widening yield spread between long-term and short-term interest rates (i.e a steepening or upward sloping yield curve) indicates an expectation of an increase in real economy activity (economic upturn) because investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates in the future, which can both hurt bond returns When inflation is rising, the Federal Reserve will often raise interest rates to fight inflation o When yield spread is expected to narrow, it is preferred to invest in shorter duration bonds; • Conversely, negative or narrowing yield spread between long-term and short-term interest rates (i.e Reading 14 Capital Market Expectations a flattening or inverted yield curve) indicates an expectation of a decline in real economy activity (economic downturn or recession) because an anticipation of a recession implies the expectation of a decline of future interest rates that is reflected in a decrease of long-term interest rates In other words, if investors expect a reduction of their income, in case of a recession, they prefer to save and invest in long-term bonds in order to get payoffs in the recession Consequently, the demand for long-term bonds increase, leading to a decrease of the corresponding yield Further, to finance the purchase of the long-term bonds, an investor may sell short-term bonds whose yields will increase As a result, when a recession is expected, the yield curve flattens or gets inverted o When yield spread is expected to widen, it is preferred to invest in longer-duration bonds; FinQuiz.com for long What happens when Interest Rates Reach Zero? Once interest rates are at zero, the monetary authorities can stimulate the economy using the following measures: 1) The central bank can push cash (bank “reserves”) directly into the banking system 2) The central bank can devalue the currency 3) The central bank can promise to keep short-term interest rates low for an extended period 4) The central bank can buy assets directly from the private sector (process called open market purchase); as a result, spending increases as money is put directly into people’s hands and yields on these assets fall Price indices are used to identify the overall trend in prices For example, 4.1.3) Inflation and Deflation in the Business Cycle Inflation refers to continuous (not one time) increase in aggregate price level, resulting in decrease in the purchasing power of a unit of currency Inflation is linked to business cycle i.e • It tends to increase during late stages of a business cycle when there is no output gap which puts upward pressure on prices • It tends to fall during recessions and the early stages of recovery when there is a large output gap which puts downward pressure on prices Deflation refers to continuous (not one time) decrease in aggregate price level, resulting in increase in the purchasing power of a unit of currency It negatively affects the economy in two ways: i Deflation tends to reduce the value of debt-financed investments because when the price of a debtfinanced asset falls, the value of the “equity” in the asset (i.e asset’s value - loan balance) tends to decline at a leveraged rate E.g if the value of a property financed with 67% loan-to-value mortgage decreases by 5%, the value of equity in the property will fall by = 5% / (1 – 0.67) = 5% / 0.33 = 15.15% ii Deflation tends to undermine central bank’s ability to affect monetary policy to control the economy: During deflation, interest rates are near to zero; as a result, the central bank is unable to stimulate the economy with monetary policy (i.e by lowering interest rates below zero) • Therefore, in order to keep inflation at low level but without pushing the economy into deflation, central banks prefer to use a low positive rate of target inflation • An economy may suffer from a prolonged deflation when its money supply is restricted; e.g in gold standard currency system, the money supply was restricted by the size of a government’s gold reserves By contrast, when the money supply can be easily expanded, deflation does not tend to last • Consumer price index: It is calculated using a basket of goods and services based on consumers’ spending patterns • GDP and consumer expenditure deflators: They are used to adjust or deflate the nominal series for inflation Three principles of Central bank Policy regarding inflation: A Central banks’ policy-making decisions must be free from political influence; otherwise, central banks may use easy monetary policy which leads to increase in inflation over time B Central banks should have an inflation target which serves dual roles i.e act as a disciplining tool for central bank itself and as a signal of central bank’s intention to the market It also helps to anchor market expectations C Central banks should use monetary policy (primarily interest rates) to manage the economy and to prevent it from either overheating or suffering from a recession for too long Practice: Example 24, Volume 3, Reading 14 4.1.4) Market Expectations and the Business Cycle It is quite difficult to identify the current phase of the cycle and correctly predict the starting time of the next phase because the phases of the business cycle vary substantially in length (duration) and amplitude (intensity): For example, • Recessions can be steep with a huge decline in output and a substantial rise in unemployment; or it can be short lived with only a small decline in output and only a modest rise in unemployment Reading 14 Capital Market Expectations • Weak phase of the business cycle may involve only a slower economic growth or a “growth recession” rather than a recession This particularly occurs when: o An economy has a rapid trend rate of growth; o The upswing was relatively short or mild without bubble or severe overheating in the stock market or property market; o Inflation is relatively low; o The world economic and political environments FinQuiz.com are positive; Equity Real Estate/Other Real Assets Cash Bonds Inflation at or below expectations Short-term yields steady or declining (Neutral) Yield levels maintained; Market is in equilibrium (Neutral) Bullish while market is in equilibrium state (Positive) Cash flow steady to rising slightly Returns equate to long-term average Market in general equilibrium (Neutral) Inflation above expectations Bias toward rising rates (Positive) Bias toward higher yields due to a higher inflation premium • As yields ↑, nominal bond price ↓; also, bond coupon & principal become less attractive on real basis; (Negative) High inflation is negative for financial assets Less negative for companies/ industries able to pass on inflated costs (Negative) Asset values increasing; increases cash flows and higher expected returns (Positive) Deflation Bias toward 0% short-term rates (Negative) Purchasing power increasing Bias toward steady to lower rates (may be offset by increased risk of potential defaults due to falling asset prices) (Positive) Negative wealth effect slows demand Especially affects asset-intensive, commodityproducing (as opposed to commodity-using), and highly levered companies (Negative) Cash flows steady to falling Asset prices face downward pressure (Negative) Source: Curriculum, Reading 14, Exhibit 18 4.1.5) Evaluating Factors that Affect the Business Cycle In formulating capital market expectations, the business cycle analysis should be performed by focusing on the following four areas: 1) Consumer spending: The consumer spending represents 60-70% of GDP in most large developed economies Thus, it is regarded as the most important business cycle factor Unlike business investments, it is quite stable over the business cycles • Sources of data on consumer spending: Retail sales, miscellaneous store sales data, consumer confidence survey data (indicates changes in household’s saving rates), and consumer consumption data • Factor that affects consumer spending: Consumer spending largely depends on consumer income after tax which in turn depends on wage settlements, inflation, tax changes, and employment growth In addition, consumer spending can also be affected by unusual weather or holidays • Assuming household savings rate constant, ∆ in income = ∆ in consumer spending 2) Business investment: Business investment represents a smaller % of GDP relative to consumer spending Business investment and spending on inventories are regarded as the most volatile business cycle factor • Sources of data on business investments: Purchasing managers index (PMI) which is based on answers to a series of questions about the company’s position, including production plans, inventories, prices paid, prices received, and hiring plans Reading 14 Capital Market Expectations o Rising inventory levels during early stages of an inventory cycle upswing may indicate that businesses are spending on inventories as they expect sales to increase in future, reflecting higher economic growth o Rising inventory levels during late stage of the inventory cycle may indicate that inventory levels are increased due to lower than expected sales 3) Foreign trade: For large economies (e.g U.S & Japan), this factor represents a smaller % (i.e 10-15%) of GDP and therefore, considered as a less important factor; whereas for smaller economies foreign trade is an important factor, representing 30-50% of GDP, in general 4) Government Policy: Both the government and monetary authorities tend to control the growth rate of the economy to keep it close to its long-term sustainable trend rate and attempt to meet inflation target using different policies i.e • Monetary policy: Easy (tight) monetary policy involves reducing (increasing) short-term interest rates and/or increasing (decreasing) money supply Easy (tight or restrictive) monetary policy is used when the economy is weak (in danger of overheating) o Over the long-run, the growth in money supply and the growth in nominal GDP are positively related i.e as money supply increases, nominal GDP increases, leading to increase in inflation o Monetary policy focuses on key variables, including the pace of economic growth, amount of excess capacity still available (if any), unemployment level, and inflation rate • Fiscal policy: Easy (tight) fiscal policy involves reducing (increasing) tax rates and/or increasing (decreasing) governmental spending FinQuiz.com which the potential growth of the economy is in balance with target inflation rate E.g if the target inflation rate is 2% and economic growth is 2.5%, the neutral level of interest rates = 2% + 2.5% = 4.5% The Taylor Rule: This rule relates a central bank’s target short-term interest rate to the rate of growth of the economy and inflation Taylor rule equation: Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)] + [0.5 × (Iforecast – Itarget)] Where, Roptimal Rneutral GDPgforecast GDPgtrend Iforecast Itarget = the target for the short-term interest rate = the short-term interest rate that would be targeted if GDP growth were on trend and inflation on target = the GDP forecast growth rate = the observed GDP trend growth rate = the forecast inflation rate = the target inflation rate Interpretation of Taylor Rule: When forecast GDP growth rate and/or the forecast inflation rate >( taxes) in order to influence the economy • Easy or expansionary fiscal policy involves increasing government spending and/or reducing taxes to stimulate the economy • Tight or restrictive fiscal policy involves decreasing government spending and/or increasing taxes to slow the economy Following two factors must be considered in analyzing the fiscal policy: 1) Changes in the governmental budgetary deficit: It is important to focus on the changes in the governmental budgetary deficit rather than its absolute level E.g when budget deficit increases (decreases), it implies easy (tight) fiscal policy Reading 14 Capital Market Expectations 2) Deliberate changes in the budget deficit: It is important to focus only on the deliberate changes in the budget deficit in response to changes in fiscal policy rather than changes in budget deficit in response to the changes in economy, e.g during recessions or when the economy is slow (expansions FinQuiz.com or when the economy grows), tax revenues ↓ (↑) and government spending on unemployment ↑ (↓); consequently, budget deficit tends to increase (decrease) Linkages with Monetary Policy Tight Fiscal Policy Expansionary Fiscal Policy Expansionary Fiscal Policy Tight Fiscal Policy 4.2 + + + + Tight Monetary Policy Expansioary Monetary Policy Tight Monetary Policy Expansioary Monetary Policy Economic Growth Trends Economic Growth Trend: The long-term, smooth growth path of GDP is called the economic growth trend It reflects the average growth rate around which the economy rotates (i.e slows down or grows) in response to business cycles but is independent of business cycle In other words, it represents the pace of growth of economy over a number of years without any unsustainable increase in inflation The economic growth trend is determined by other economic trends, including: • • • • • Population growth and demographics Business investment and productivity Governmental structural policies Inflation/deflation Health of banking/lending processes The expected trend rate of economic growth is a key input in discounted cash flow models of expected return • The higher the trend rate of economic growth of a country, the more attractive returns for equity investors • The higher the trend rate of economic growth of a country, the more fast an economy can grow without any unsustainable increase in inflation = = = = • Economy is expected to slow • Yield curve tends to be inverted in shape • Economy is expected to grow • Yield curve tends to be steeply upward sloping • Ambiguous situation i.e unlear whether economy will slow or grow • Yield curve tends to be flat • Ambiguous situation i.e unlear whether economy will slow or grow • Bond yields tend to fall &Yield curve tends to be moderately upward sloping Practice: Example 28, Volume 3, Reading 14 4.2.1) Consumer Impacts: Consumption and Demand Consumption represents the largest source of aggregate economic growth in both developed and developing economies It is also the most stable or even countercyclical business cycle factor as explained by the permanent income hypothesis Wealth effect: When % increase in consumers’ spending is greater than % increase in consumers’ wealth (income), it is referred to as the wealth effect The permanent income hypothesis: According to the permanent income hypothesis, consumer spending behavior is largely determined by long-term income expectations rather than temporary or unexpected (or one-time) change in income/wealth • When income temporarily increases (i.e during expansions), increase in spending will be less than increase in income • When income temporarily decreases (i.e during recessions), decrease in spending will be less than decrease in income Reading 14 Capital Market Expectations 4.2.2) A Decomposition of GDP Growth and Its Use in Forecasting Trend growth in GDP = Growth from labor inputs + Growth from changes in labor productivity Where, Growth from labor inputs reflects growth from changes in employment Growth from labor inputs = Growth in potential labor force size + Growth in actual labor force participation Growth from changes in labor productivity = Growth from capital inputs + TFP growth* *TFP growth = Growth associated with increased efficiency in using capital inputs Impact of rate of investment on stock market returns: The stock market returns depend on the rate of return on invested capital i.e the higher the rate of investment the higher the growth in capital the lower the returns on invested capital; consequently, the lower the stock market returns (despite higher rate of economic growth) Practice: Example 29, Volume 3, Reading 14 4.2.3) Government Structural Policies Government structural policies are the government policies that affect the limits of economic growth and incentives within the private sector Elements of pro-growth government structural policy: Fiscal policy is sound: Regularly running a large budget deficit does not indicate a sound fiscal policy A sound fiscal policy is the one in which budget deficit is close to zero over the long-run Following are the three problems associated with running large budget deficits on a consistent basis: i Twin deficits problem and currency devaluation: An economy may need to borrow from abroad to finance its budget deficit, that is, by running current account deficit When level of foreign debt rises considerably, an economy needs to reduce borrowing, usually through devaluing its currency ii Higher inflation: If the budget deficit is financed by printing money, it results in higher inflation in the economy iii Crowding-out effect: Government borrowing to finance budget deficit puts upward pressures on interest rates The higher interest rates can cause lower private sector spending and investment FinQuiz.com The public sector has minimal interference with the private sector: There should be minimal government intervention in the economy because excessive government intervention, particularly in the form of regulations, creates inefficiency and leads to a misallocation of scarce resources For example, labor market rules tend to increase the structural level of unemployment (i.e unemployment resulting from scarcity of a factor of production) Competition within the private sector is encouraged: Competition within the private sector makes the companies more efficient and consequently increases productivity growth of an economy Government policies that encourage competition within the private sector include reduction of trade tariffs and barriers, removal of restrictions on foreign investment etc However, due to higher competition it becomes difficult to earn high returns on capital; as a result, stock market valuations decrease Infrastructure and human capital development are supported: Governments must pursue infrastructure and human capital development (i.e education & health) projects because they have important economic benefits Tax policies are sound: Sound tax policies involve simple, transparent, stable and low marginal tax rates, and a very broad tax base Generally, taxes represent 30-50% of GDP in many developed economies 4.3 Exogenous Shocks In general, it is relatively easy to forecast trends than cycles because they are relatively constant over time Therefore, trends or changes in trends are already discounted in market expectations and prices by investors However, some trends are not forecastable These are referred to as “exogenous shocks” e.g short-lived political events, wars, abrupt changes in government tax or trade policies, sudden collapse in an asset market or in an exchange rate, natural disasters etc Two major types of economic shocks with contagion effects include: 1) Oil shocks (section 4.3.1): Oil shocks refer to a sharp increase in the price of oil, which reduces consumer purchasing power and creates higher inflation Over time, as employment falls and economy slows down, the output gap opens up; consequently, inflation decreases to its previous level 2) Financial shocks (section 4.3.2): Financial shocks are associated with country’s inability to meet debt payments, devaluation of currency, and considerable decline in asset prices, (particularly real estate prices) Usually, banks are highly vulnerable to financial shocks Financial shocks reduce economic growth Reading 14 Capital Market Expectations either directly through decreased bank lending or through decreased investor confidence Financial crises are potentially more dangerous in a low interest rate environment because during such environment, the central bank is unable to further reduce interest rates for the purpose of providing sufficient liquidity in the economy 4.4 International Interactions Small countries with concentrated economies (depending on a few commodities) tend to be highly influenced by developments in other economies in the world compared to large countries with diverse economies (e.g U.S.) However, international interactions among countries in the world have increased with increase in globalization of trade, capital flows, and direct investment Types of International Interactions: 1) Macroeconomic Linkages: Economies are linked through two broad channels • Trade in goods and services: For example, as foreign demand for exports increase, the exports increase aggregate demand increase and consequently, economic growth increases • Finance: As international investors shift their assets around the world, they link asset markets here and abroad, it affects income, exchange rates, and the ability of monetary policy to affect interest rates 2) Interest Rate/Exchange Rate Linkages: These linkages affect countries that unilaterally peg their currencies firmly or loosely to one of the major currencies (e.g U.S dollar) The pegging exchange rates policy has two benefits: i It reduces the volatility of the exchange rate (at least in the short-run) ii It enables the pegged country to control inflation iii It imposes some discipline on government policies Limitations of pegging exchange rate policy: i It can introduce currency speculation ii In pegging exchange rate regime, the level of domestic interest rates will depend on overall market confidence in the peg i.e the higher (lower) the confidence in the exchange rate peg, the lower (higher) the interest rate differential (bond yields of pegged country – bond yields of the major currency country) Bond yields of the country with undervalued (overvalued) exchange rate tend to be lower (higher) NOTE: Real and nominal rates tend to be high when there is: • Increasing Budget deficit FinQuiz.com • Strong private sector economy (reflecting strong demand for world savings) • Tight monetary policy 4.4.3) Emerging Markets 4.4.3.1 Essential Differences between Emerging and Major Economies • Emerging countries need higher rates of investment in physical capital and infrastructure and in human capital than developed countries • Due to inadequate domestic savings (unlike developed countries), emerging countries heavily depend on foreign capital (i.e foreign debt) • Emerging countries tend to have a highly volatile political and social environment than developed countries, which makes it difficult to achieve structural reforms • Emerging countries tend to have a relatively large % of people with low income and few assets and a relatively small middle class • Emerging countries tend to have concentrated economies e.g with particular commodities or in a narrow range of manufactured goods • Due to heavy reliance on oil imports, emerging countries tend to be more sensitive to fluctuation in oil prices or rely heavily on continuing capital inflows • Emerging countries tend to have excessive shortterm debt 4.4.3.2 Country Risk Analysis Techniques • For emerging countries’ bonds, investors focus on assessing the risk of default of the country • For emerging countries’ stocks, investors focus on the assessing the growth prospects of emerging countries and their sensitivity to surprises Key Elements of Country Risk Analysis: Soundness of fiscal and monetary policy: Persistently large budget deficits tend to reduce economic growth In addition, the larger and the more persistent the fiscal deficit, the greater the debt The soundness of fiscal policy is assessed through ratio of fiscal deficit to GDP i.e • When ratio of fiscal deficit to GDP is persistently > 4%, it is regarded as risky, indicating substantial credit risk; • When ratio of fiscal deficit to GDP is between 2-4%, it is acceptable but still risky • When ratio of fiscal deficit to GDP < 2%, it is regarded as safe • Ratio of debt to GDP > 70-80% is regarded as extremely dangerous Economic growth prospects for the economy: • Annual growth rates of < 4% is not favorable because it indicates that the country is slowly catching up with the industrial countries and per Reading 14 Capital Market Expectations capita income is growing very slowly or even falling • The structural health of an economy can be gauged using the Economic Freedom Index, an index based on a range of indicators of the freedoms enjoyed by the private sector i.e tax rates, tariff rates, and the cost of setting up companies Higher value of Economic Freedom Index indicates greater economic growth Degree of competitiveness of Currency and the level of external accounts: • When currency stays overvalued for a prolonged time period it indicates increase in external debt and large current account deficit Also, an overvalued and highly volatile currency negatively affects business confidence and investment • The sustainability of the external accounts can be measured using size of the current account deficit i.e o Ratio of current account deficit to GDP persistently > 4% is regarded as risky o Ratio of current account deficit to GDP between 1-3% is regarded as sustainable provided that a country is growing o A current account deficit is less sustainable when it is financed through debt because it will likely lead to currency depreciation and economic slowdown As the economy slows down imports fall current account deficit is reduced o A current account deficit is more sustainable when it is financed through foreign direct investment because foreign direct investment creates productive assets The level of external debt: External debt is the foreign currency debt owed to foreigners by both the government and the private sector It serves to fund the savings deficit resulting from insufficient domestic savings The sustainability of the external debt can be measured using • Ratio of foreign debt to GDP i.e o Ratio of foreign debt to GDP > 50% indicates risky level o Ratio of foreign debt to GDP between 25-30% is regarded as the ambiguous level • Ratio of debt to current account receipts i.e o Ratio of debt to current account receipts > 200% indicates risky level o Ratio of debt to current account receipts < 100% indicates safe level Level of liquidity: Liquidity refers to level of foreign exchange reserves compared to trade flows and short-term debt (debt with maturity of < 12 months) • Adequate level of foreign exchange reserves is regarded as equal to the value of three months’ worth of imports • Ratio of foreign reserves to short-term debt i.e o Ratio of foreign reserves to short-term debt > 200% FinQuiz.com indicates safe level o Ratio of foreign reserves to short-term debt < 100% indicates risky level Political situation in relation to the required policies: • Political situation must be supportive of the required structural reforms and policies (i.e privatization and the ending of monopolies) • Strong and less volatile political environment is highly important for countries with weak economy, slow growth, slow policy liberalization, high debt and low reserves 4.5 Economic Forecasting Following are the three economic forecasting approaches: 1) Econometric Modeling: This method is a formal and mathematical approach to economic forecasting as it involves use of econometric models Econometric model comprises equations, which seek to model the relationships between different economic variables based on some sound economic theory to forecast the future E.g GDP Growth = α + β1Consumer spending growth + β2Investment growth Consumer spending growth = α + β1Lagged consumer income growth + β2Interest rate Investment growth = α + β1Lagged GDP growth + β2Interest rate • Econometric models vary from small models with just one equation or complex models with hundreds of equations • It must be stressed that larger models with multiple variables are not necessarily superior to smaller models Strengths of Econometric modeling: • Econometric models can be quite robust and may provide forecasts close to reality • Econometric models consolidate existing empirical and theoretical knowledge of how economies function • Econometric models provide quantitative estimates of the effects of changes in exogenous variables on the economy • Econometric models help to explain their own failures, as well as provide forecasts and policy advice • Econometric models restrict the forecaster to a certain degree of consistency • Econometric models are useful to forecast economic upturns/expansions Reading 14 Capital Market Expectations • Econometric models can be modified readily to accommodate changing conditions Limitations of Econometric modeling: • Econometric models may be quite complex and time-consuming to build; difficult to implement; and expensive to maintain • Econometric models are not useful to forecast recessions • Econometric models depend on adequate measures for the real-world activities and relationships to be modeled, data on which may not be easily available • Variables in the econometric models may be measured with error • Econometric models assume constant relationships among variables; hence, they may be misspecified when relationships change over time due to changes in the structure of the economy • Econometric models need forecasters to conduct careful analysis of output 2) Economic Indicators: Economic indicators are economic statistics provided by government and established private organizations They provide information on an economy’s recent past activity or its current or future position in the business cycle Types of Economic Indicators: Following are the three types of economic indicators A Leading Economic Indicator (LEI): LEIs are indicators that change before the change in the economy i.e they tend to exhibit declining (rising) trend before the economy declines (rises), e.g stock market returns They reflect future economic activity and therefore help to predict the future performance of economy They are regarded as the most important type of economic indicators for investors Leading indicatorbased analysis is the simplest forecasting approach because it involves only a limited number of variables B Coincident Economic Indicator: Coincident economic indicators are indicators that change simultaneously with the economy, e.g GDP They reflect current economic activity C Lagging Economic Indicator: Lagging economic indicators are indicators that change with some time lag with the change in the economy (i.e., a few months after the economy does) E.g unemployment rate tends to fall after a few months of economic growth They reflect recent past economic activity Composite LEIs or LEI index: Composite LEIs is a collection of economic data releases that reflect an overall future performance of the economy • Compared to individual leading indicators, LEI index is less useful for predicting the economic activity because some of its components are already public FinQuiz.com Diffusion index: Diffusion index is a measure that reflects number of upward trending indicators and downward trending indicators E.g if out of 10 indicators are exhibiting downward trend, it indicates that an economy is likely to contract General rule: Three consecutive months of increases (decreases) in LEIs give signals of upturn (downturn) in the economy within three to six months Strengths of Economic Indicators: • They are usually intuitive and simple to construct • They are easily available from third parties • They can be easily tailored according to individual needs • A literature suggests that they are effective in assessing outlook of an economy Limitations of Economic Indicators: • It has been observed in the past that they are not effective on a consistent basis due to changes in the relationships between inputs • They may provide false signals • Some data series are reported with a lag • Some data series are subject to revisions U.S Composite Indices Leading Index Average weekly hours, manufacturing Average weekly initial claims for unemployment insurance Manufacturers’ new orders, consumer goods and materials Vendor performance, slower deliveries diffusion index Manufacturers’ new orders, non-defense capital goods Building permits, new private housing units Stock prices, 500 common stocks Financial Money supply, M2 components; All else are non-financial Interest rate spread, 10-year Treasury components bonds less federal funds 10 Index of consumer expectations Coincident Index Employees on nonagricultural payrolls Personal income less transfer payments Industrial production Manufacturing and trade sales Lagging Index Average duration of unemployment Inventory/sales ratio, manufacturing and trade Labor cost per unit of output, manufacturing Average prime rate Commercial and industrial loans Consumer installment credit to personal income ratio Consumer price index for services Reading 14 Capital Market Expectations 3) Checklists Approach: This method involves subjective integration of the answers to a set of relevant questions The information gathered through answers can be extrapolated into forecasts in two ways i.e objective statistical methods (i.e time series analysis) or subjective or judgmental means to assess the outlook for the economy Strengths of Checklists approach: • It is a simple and straightforward method • It provides flexibility as the forecaster is allowed to quickly incorporate structural changes in the economy by changing the variables or the weights assigned to variables within the analysis Limitations of Checklists approach: • It is time-consuming because it requires analysis of broad range of data • It depends on subjective judgment • It is based on a process, which is manual in nature which makes it difficult to use for modeling complex relationships Guideline Set of Questions used to assess the outlook of the economy: What is the position of the economy in the business cycle? It is judged by analyzing • Previous data on GDP growth and its components; • Degree of unemployment relative to estimates of “full employment” and its trend i.e declining or increasing; • Output gap; • Businesses’ inventory position; • Level of inflation relative to target and its trend i.e rising or declining; How strong is the consumer spending? It is judged by analyzing • Wage/income patterns; • Pace of growth of employment; • Consumers’ level of confidence i.e using consumer confidence indices; How strong is the business spending? It is judged by • Reviewing survey data i.e purchasing managers indices; • Reviewing recent capital goods orders; • Assessing balance sheet health of companies; • Assessing cash flow and earnings growth trends; • Assessing trend of stock market i.e is it rising or falling; • Reviewing inventory position i.e low inventory/sales ratio implies GDP strength; What is the degree of import growth? It is judged by FinQuiz.com • Analyzing exchange rate competitiveness and recent movements; • Assessing strength of economic growth; Reviewing government’s fiscal stance; Reviewing monetary stance i.e • Recent changes in interest rates; • Trend in real interest rates; • Level of current interest rates in relation to the rate under Taylor rule; • Monetary conditions indices i.e trends in asset prices and exchange rate; • Money supply indicators; What is the trend of Inflation? i.e is it rising or falling; Practice: Example 30, Volume 3, Reading 14 4.6 Using Economic Information in Forecasting Asset Class Returns 4.6.1) Cash and Equivalents Cash includes short-term debt (e.g commercial paper) with maturity of less than or equal to one year • Given no change in overnight interest rates, longermaturity paper tends to pay higher interest rate than shorter-maturity paper because of greater risk of loss associated with their long-term maturity • When overnight interest rates are expected to increase over time, then longer-maturity paper tends to pay even higher rates than shorter-term paper Investment strategy during rising interest rate period: During periods of rising short-term rates, an investment strategy of buying shorter-maturity paper is preferred because it is profitable to reduce the duration of bond portfolio when the yield curve is upward sloping Investment strategy during declining interest rate period: During periods of declining short-term rates, an investment strategy of buying longer-maturity paper is preferred because it is profitable to increase the duration of bond portfolio when the yield curve is flat or inverted Practice: Example 31, Volume 3, Reading 14 4.6.2) Nominal Default-Free Bonds Nominal default-free bonds are conventional bonds with zero or minimal default risk Reading 14 Capital Market Expectations • Default-risk-free bonds have zero credit spread or default risk premium • Relative value of default-risk-free bonds depends on real yields and inflation i.e o If inflation is expected to increase rapidly market yields ↑ consequently, value of default-risk-free bonds will fall below par value o When an economy is expected to grow strongly demand for capital ↑ as well as inflation ↑ as a result, bond yields rise (prices fall) o Changes in short-term rates have uncertain effects on bond yields: Typically, as short-term rates increase longerterm bond yields also increase (bonds price fall) Sometimes, as short-term rates increase economy slows down as a result, longer-term bond yields tend to fall (bonds price increase) o When bond markets have confidence on the ability of central banks to achieve inflation targets, then changes in inflation tend to have no impact on bond yields 4.6.3) Defaultable Debt Defaultable debt (mostly corporate debt) is debt with a substantial amount of credit risk • Credit spreads on defaultable bonds tend to widen during recessions because default rates tend to increase when economic growth slows down and business conditions weaken As the credit spreads increase bond yields increase • Credit spreads on defaultable bonds tend to narrow during expansions because when default rates tend to decline there is strong economic growth and strong business conditions As the credit spreads reduce bond yields decrease FinQuiz.com 1) Economic Growth: When the economy is strong (weak), real yields are high (low) consequently, real yields on inflation-indexed bonds will be higher (lower) 2) Inflation expectations: Inflation-indexed bonds provide hedge against inflation risk Hence, the higher (lower) the inflation and the more (less) volatile it is, the greater (lower) the value of indexed bonds in providing protection against inflation risk and consequently, the lower (higher) the yields on inflation-indexed bonds 3) Supply of indexed bonds versus investors’ demand for indexed bonds: When investors’ demand for indexed bonds is greater (lower) than supply, yields on inflation-indexed bonds are lower (higher) The real yield is also affected by tax effects and the limited size of the market 4.6.6) Common Shares 4.6.6.1 Economic Factors Affecting Earnings Over the long-run, the trend growth in aggregate company earnings is positively correlated with the trend rate of growth of the economy i.e the higher (lower) the growth of the economy, the greater (lower) the average earnings growth because: • During the early stages of an economy upswing capacity utilization rises and employment increases; however, the wages are still not higher due to relatively high unemployment as a result, profits are higher and earnings are strong During later stages of an economy upswing wages start to increase quickly profits are reduced and earnings growth slows down • During recessions sales reduce, capacity utilization is low earnings are depressed 4.6.4) Emerging Market Bonds Emerging market debt is the sovereign debt of nondeveloped countries Emerging market debt is denominated in foreign currency; as a result, it tends to have higher risk of default The risk of emerging market bonds is assessed in terms of their spread over domestic Treasuries compared to similarly rated domestic corporate debt 4.6.5) Inflation-Indexed Bonds Inflation-indexed bonds are bonds that pay a fixed coupon (the real portion) plus an adjustment equal to the change in consumer prices For example, Treasury Inflation-Protected Securities (TIPS) in the U.S and IndexLinked Gilts (ILGs) in the U.K • Inflation-indexed bonds are perfectly risk-free assets because they have no risk from unexpected inflation • Nevertheless, the yield on inflation-indexed bonds is not constant and change over time in response to the following three economic factors: Important to Note: • Equity returns are positively affected by accelerating economic growth, decreasing interest rates and strong growth in consumer and business sector • Cyclical industries (with large fixed costs and a pronounced sales cycle) tend to have higher sensitivity to business cycles, e.g car manufacturers and chemical producers • The sales, earnings, and dividends of “Pro-cyclical” industries tend to have large positive correlation with GDP • When an industry’s earnings have higher correlation with inflation and interest rates, it has a higher ability to pass through to customers the increased costs of higher inflation and interest rates • Export-oriented companies perform well when domestic currency depreciates • Companies with higher (lower) earnings growth rate during recessions tend to have higher (lower) valuations Reading 14 Capital Market Expectations Practice: Example 32 & 33, Volume 3, Reading 14 4.6.6.2 The P/E Ratio and the Business Cycle The price-to-earnings ratio of a stock market reflects the price that the market is willing to pay for the earnings of that market • The P/E ratio tends to increase (decrease) when earnings are expected to rise (fall) • The P/E ratio tends to be high during the early stages of an economic recovery • The P/E ratio tends to be high when interest rates are low and fixed-rate investments (i.e cash or bonds) offer less attractive return • The P/E ratio tends to be low when inflation is high because investors assign lower value to reported earnings during inflationary periods Hence, it is not appropriate to compare current P/E with past average P/E without controlling for the difference in inflation rates Molodovsky Effect: P/Es of cyclical companies tend to be high at the bottom of a business cycle (i.e economic downturns) due to expectations of rise in future earnings when the economy recovers and tend to be low at the top of a business cycle 4.6.6.3 Emerging Market Equities • Ex-post equity risk premiums for emerging markets, on average, tend to be higher and more volatile than those in developed markets • Ex-post, emerging market equity risk premiums in U.S dollar terms tend to have positive correlation with business cycles in developed countries Transmission channels for G-7 macroeconomic fluctuations to developing economies include trade (the higher the growth in G-7 economies, the greater the demand for the goods produced by emerging countries i.e natural resources), finance, and direct sectoral linkages 4.6.7) Real Estate Systematic Determinants of Real estate returns include: • Growth in consumption • Real interest rates (that reflect construction financing costs and the costs of mortgage financing): Generally, lower interest rates imply lower capitalization rates and consequently, net positive return for real estate valuation • Term structure of interest rates • Unexpected inflation FinQuiz.com 4.6.8) Currencies Exchange rate is affected through various channels i.e Trade: All else being constant, when imports of a country increase (decrease), the domestic currency tends to depreciate (appreciate) Finance: Exchange rate is also affected by international flows of capital resulting from foreign direct investment as well as from investments in stocks, bonds, or short-term instruments, including deposits • As domestic economic growth increases and new industries are opened to foreign ownership, foreign direct investment increases and consequently, domestic currency appreciates Capital inflows associated with foreign direct investment are considered to be more stable and less volatile compared to capital inflows associated with investments in stocks and bonds • As domestic interest rates increase, investments in domestic bonds, short-term instruments, or deposits increase capital inflows increase domestic currency appreciates • However, domestic currency may depreciate rather than appreciate when investors expect economic slowdown due to higher interest rates 4.6.9) Approaches to Forecasting Exchange Rates There are four broad approaches to forecasting exchange rates 1) Purchasing Power Parity (PPP): According to PPP, differences in inflation between two countries should be reflected in the changes in the exchange rate between them That is, the currency of a country with relatively higher (lower) inflation tends to depreciate (appreciate) against the other currency For example, suppose that prices in Country A are expected to increase by 4% over the next year while prices in Country B are expected to rise by only 2% The inflation differential between the two countries is: 4% – 2% = 2% • This implies that increase in prices in Country A is greater than that of Country B The PPP approach forecasts that Country A’s currency will have to depreciate by approximately 2% to keep prices between countries relatively equal • If current exchange rate is 0.90 units of Currency A per unit of Currency B, then under the PPP approach, an exchange rate is forecasted to be = (1 + 2%) × (0.90 A per B) = 0.918 units of Currency A per unit of Currency B PPP is more useful to forecast direction of exchange rates in the long-run (≥ years) It is not useful in the short or even medium run (up to years) Practice: Example 34, Volume 3, Reading 14 Reading 14 Capital Market Expectations 2) Relative Economic Strength: According to relative economic strength forecasting approach, strong economic environment and favorable investment climate attract investments from foreign investors (i.e investment flows) which in turn increases demand for the domestic currency and consequently, domestic currency appreciates in value • In addition, when domestic country has higher shortterm deposit rates (reflecting higher yield on investments) demand for domestic currency increases and consequently, domestic currency appreciates in value • When domestic interest rates are low, it may induce investors to avoid investing in a particular country or even borrow that currency at low interest rates to fund other investments (known as carry-trade) Unlike PPP approach, the relative economic strength approach does not predict about the level of exchange rates; rather, it only helps to determine whether a currency is going to appreciate or depreciate This approach can be used in conjunction with PPP approach to develop a more complete forecast 3) Capital Flows: The capital flows forecasting approach is based on long-term capital flows i.e equity investments and foreign direct investment (FDI) According to this approach, the greater the capital inflows, the greater the demand for currency, and consequently, the stronger the currency • When short-term rates are lower economic growth increases stock markets perform well long-term investments become more attractive demand for currency increases and consequently, currency appreciates Hence, central banks face a dilemma; to strengthen depreciating currency, interest rates are required to increase, but, higher interest rates may slow down the economy, reducing the effectiveness of monetary policy 4) Savings-Investment Imbalances: The savingsinvestment imbalances forecasting approach is based on imbalance between domestic savings and investments This approach is useful to determine causes of long-term deviation of currencies from their equilibrium values According to this approach, FinQuiz.com When an economy grows rapidly but domestic savings remain constant capital investments (representing demand for savings) > supply of domestic savings the investment must be financed from foreign savings i.e from capital inflows from abroad or through increase in imports; in other words, current account deficit (imports > exports) is needed And in order to increase imports or to attract and keep the capital inflows needed to fund savings deficit, the domestic currency must appreciate in value (either as a result of higher interest rates or through strong economic growth) • Eventually, as the currency strengthens and domestic investments fall current account deficit widens and the domestic currency may start to decline, leading to current account surplus NOTE: Current account deficit of a country = Government deficit + Private sector deficit Practice: Example 36, Volume 3, Reading 14 4.6.10) Government Intervention It is difficult for governments to control exchange rates via market intervention alone because of the following three factors: 1) The total foreign exchange reserves of major central banks combined is small compared to the total value of foreign exchange trading (>US$1 trillion daily) 2) Exchange rates depend on various fundamental factors besides government authorities 3) It is difficult to control exchange rates without imposing capital controls Practice: End of Chapter Practice Problems for Reading 14 & FinQuiz Item-set ID# 19084 &12513 ... surveys largely depends on the professional identity of the respondent Practice: Example 18 &19, Volume 3, Reading 14 3. 3 3. 2 Survey and Panel Methods In the Survey method of capital market expectations... (lower) valuations Reading 14 Capital Market Expectations Practice: Example 32 & 33 , Volume 3, Reading 14 4.6.6.2 The P/E Ratio and the Business Cycle The price-to-earnings ratio of a stock market... -0.5% and P/E re-pricing return of 0 .35 % Expected return on the stock = 2.0% + 3. 2% + 4.5% - 0.5% + 0 .35 % = 9.55% Practice: Example 13 &14, Volume 3, Reading 14 Fed Model: According to the Fed