Portfolio Management Unit – III Session No. 21 Topic: Economic Analysis Session Plan • Recap the previous session • Economic Analysis – Business Cycle – Economic Growth trends supports for Economic Analysis – Exogenous Shocks • Summarizing and Q & A Economic Analysis • Economic Analysis helps the Analyst in understand: – Lead–lag relationships between economic variables and capital market returns. – Current economic environment has a competitive advantage – Expectations for future asset returns, and economic activity – Forecast a change in trend or point of inflection in economic activity – Driving the economy in its current expansion or contraction phase – Helping to maintain economic growth, demand, supply, and/or inflation rates within their current ranges – Cyclical variation affects variables such as corporate profits and interest rates Economic Analysis • • • • In business cycle analysis, two cycles are generally recognized: A short-term inventory cycle, typically lasting 2 to 4 years, and A longer-term business cycle, usually lasting 9 to 11 years. In particular, they can be disrupted by major shocks, including wars and shifts in government policy. • Cycles mark variation in economic activity, so we should be clear on how that variation is measured. • The chief measurements of economic activity are as follows: – GDP – Output gap – Recession Economic Analysis • Gross domestic product (GDP). • GDP is a calculation of the total value of final goods and services produced in the economy during a year. • The main expenditure components are consumption, investment, change in inventories, government spending, and exports less imports. • To focus on increases in the quantity (output) of goods and services produced—which are directly associated with increases in the standard of living—rather than on price-driven increases in the value of output, economists focus on real GDP Economic Analysis • Output gap. • The output gap is the difference between the value of GDP estimated as if the economy were on its trend growth path (sometimes referred to as potential output) and the actual value of GDP. • A positive output gap opens in times of recession or slow growth. • When a positive output gap is open, inflation tends to decline. Once the gap closes, inflation tends to rise. • Recession. • In general terms, a recession is a broad-based economic downturn. More formally, a recession occurs when there are two successive quarterly declines in GDP. Economic Analysis 1. The Inventory Cycle • Economists have found evidence of a short-term inventory cycle, lasting 2 to 4 years. • The inventory cycle is a cycle measured in terms of fluctuations in inventories. • The inventory cycle is caused by companies trying to keep inventories at desired levels as the expected level of sales changes. • In the up phase of the inventory cycle, businesses are confident about future sales and are increasing production. • In the recent past, a tightening of monetary policy has often caused this inflection(variation) point. It could also be caused by a shock such as higher oil prices. • Then, business cuts back production to try to reduce inventories and hires more slowly (or institutes layoffs). The result is a slowdown in growth. Economic Analysis 2. The Business Cycle • In addition to the inventory cycle, there is evidence of a longer cycle, often lasting 9 to 11 years, called the business cycle. The business cycle represents fluctuations in GDP in relation to long-term trend growth. • A typical business cycle has five phases: • • • • • Initial Recovery : This is usually a short phase of a few months in which the economy picks up from its slowdown or recession Early Upswing: After the initial recovery period, confidence is up and the economy is gaining some momentum. Late Upswing: At this stage of the cycle, the output gap has closed and the economy is in danger of overheating. Slowdown: At this point, the economy is slowing, usually under the impact of rising interest rates. The economy is especially vulnerable at this juncture to a shock, which can turn a ‘‘soft landing’’ into a recession., and Recession: recession is conventionally defined as two successive quarterly declines in GDP. There is often a large inventory pullback and sometimes a large decline in business investment. Economic Analysis Economic Analysis • Evaluating Factors that Affect the Business Cycle • For the purposes of setting capital market expectations, we need to focus business cycle analysis on four areas: • 1. Consumers: Consumer spending amounts to 60 to 70 percent of GDP in most large developed economies and is therefore typically the most important business cycle factor. • 2. Business: Business investment has a smaller weight in GDP than consumer spending but is more volatile. • 3. Foreign trade: Foreign trade is an important component in many smaller economies, for which trade is often 30 to 50 percent of GDP. • 4. Government activity, both monetary policy (concerning interest rates and the money supply) and fiscal policy (concerning taxation and governmental spending). Economic Analysis • • • • • • Economic Growth Trends The economic growth trend is the long-term growth path of GDP. The long-term growth path reflects the average growth rate around which the economy cycles. The differences between economic trends and cycles need to be understood. Economic trends exist independently of the cycle but are related to it. Business cycles take the economy through an alternating sequence of slow and fast growth, often including recessions and economic booms. • Consumer Impacts: Consumption and Demand • A Decomposition of GDP Growth and Its Use in Forecasting • Government Structural Policies Economic Analysis • Exogenous Shocks • Exogenous shocks are events from outside the economic system that affect its course. • These could be short-lived political events, changes in government policy, or natural disasters, for example. • They are typically not built into prices or at most are only partially anticipated. • The biggest impact occurs when there is new government or a major institutional shift. • For example, a major fiscal law that prevents the government from borrowing beyond certain limits can be a very effective constraint on excessive spending. • Shocks cannot be forecast in general. • Two types of economic shock that periodically affect the world economy • 1. Oil shocks are important because a sharp rise in the price of oil reduces consumer purchasing power and also threatens higher inflation. • 2. Financial shocks, which can arise for a variety of reasons, threaten bank lending and therefore economic growth. Economic Analysis 1. Oil Shocks Crises in the Middle East regularly produce spikes in oil prices. • Military conflicts that led to declines in world production of oil occurred in 1973 to 1974, 1979, 1980, 1990, and 2003 to 2004. • Even though oil is a smaller input to the world economy now than it was in the 1970s, a sudden rise in prices affects consumers’ income and reduces spending. • Inflation rates also rise, though here the effect is ambiguous. • Although inflation moves up initially, the contractionary effect of higher oil prices restricts employment and opens up an output gap so that, after a period, inflation slows to below the level. • There have also been episodes of declining oil prices, most notably in 1986 and again in 1999. These tend to have the effect of extending the economic upswing because they contribute to lower inflation. • Dependence on Middle East oil remains high, and the sources of political instability in the region remain numerous. Economic Analysis • • • • • • • • 2. Financial Crises Periodic financial crises affect growth rates either directly through bank lending or indirectly through their effect on investor confidence. In the last few decades, events in emerging markets have been the cause of several crises. The Latin American debt crisis of 1982, the Mexican currency crisis of 1994, the Asian financial crisis of 1997, and the Russian crisis of 1998 are examples. The last was particularly important because it threatened both financial markets and investment banks with widespread collapse. The reason was a possible domino effect due to the subsequent collapse of Long-Term Capital Management (LTCM), a large U.S. hedge fund. Most of LTCM’s positions had been based on expectations of declining risk spreads. Banks are always potentially vulnerable after a major decline in asset prices, particularly property prices, as in the United States in the early 1990s. In that case, the Fed’s response was to keep interest rates low for a prolonged period to provide sufficient liquidity to ensure that the payment system could continue. That action would have been more difficult in a world of low inflation or deflation. Financial crises are therefore potentially more dangerous in a low interest rate environment.