Business Cycles and Corporate Management Prof. Dr. Oscar Bernal – oscar.bernal@unamur.be Lille, September 2018 General information • Business cycles and corporate management: one course, three main parts – Underlying theory for business cycles analysis; 8h – More details on the labour market; 4h – Putting it altogether, the macroeconomic outlook; 4h • Course grading (i) Multiple choice exam (40%) (ii) Written report on sectorial risk (groups of 6 students) (60%) • This course differs in its presentation from BCCM given in Paris but not in its content 2 Country risk report instructions • Objective – Write a risk report for one specific sector of activity in one given country (groups of 6 students) • Content of the report – Country macroeconomic outlook (i.e. short term perspectives and upward and downward risks) – Industry recent evolution (e.g. production, turnover and profitability, change in prices and labour cost) – Competition on the domestic market from a microeconomic point of view (e.g. number of firms, rivalry, segmentation, etc.) and brief presentation of foreign competitors – Domestic and international sales vs. domestic or international indicator – Perspectives in the short term (using all relevant indicators with an emphasis on sales, volume, prices and profitability – Conclusion (i.e. what implications can be drawn for managers willing to launch a productive activity in the sector and country of interest) 3 Introduction • Why BCA matters for corporates? – Business cycles determine the economic environment in which firms make business – BC influence the behaviour of all the economic agents with which firms interact • BCA is essential to understand how the economic system actually works • BCA bridges economic theory to corporate management by allowing the identification of – Risks – Opportunities 4 Introduction • Assessing the real economy’s outlook is difficult – Lack of real time data – Complex interactions – Economic variables long-term relationships may not hold during crises • Financial markets too are difficult to understand – Volatility has surged over the last 40 years – Consequently, frequency and magnitude of financial crises has increased • Need to be able to elaborate a dynamic economic dashboard • Helpful for designing “the big picture” of economic and financial developments (think global) • Foreseeing the economic outlook is key for the management of any business (think about financing costs, labour costs, the evolution of sales and profitability, etc.) 5 Introduction • Three main objectives of this lecture – Discuss the main economic and financial mechanisms – Define the indicators allowing to monitor these mechanisms – Understand how these indicators interact and help predicting economic and financial developments to draw relevant conclusions in terms of business management 6 Contents • Focus on several (key) economic/financial concepts – – – – – – – – – – Section 1: Economic growth (p. 8) Section 2: Expectations and data (p. 24) Section 2: Inflation (p. 29) Section 4: Bond markets and interest rates (p. 41) Section 5: Stock markets (p. 56) Section 6: Forex (p. 62) Section 7: Fiscal and monetary policy (p. 71) Section 8: Putting it all together (p. 96) [Section 9: The labour market; see the respective material] [Section 10: The macroeconomic outlook; see the respective material] 7 Section 1: Economic growth How to measure economic activity? • GDP is the total production value of goods and services in an economy • GDP is a flow (measure of production value over a given year) • Expenditures approach to GDP splits it in distinct components GDP = C + I + G + X − M • Role for the private sector (C and I), for the public sector (G) and the rest of the world (X and M) 9 GDP within the Eurozone 0 EZ GE FR IT SP NL BE OE GR FI IR PT SK LU SL CY ES MA 2000 4000 2400 6000 8000 7850 1700 1250 790 500 300 GDP €bn 250 PIB en (2017) milliards d'euros (2010) 168 166 140 135 Important heterogeneity 53 32 France and Germany represent 25 14 almost 50% of the EZ GDP 9.6 5 Source: Eurostat 10 Real GDP • What are the limitations of this definition of GDP? – – – – Nothing about wealth distribution within society Nothing about structure and diversification of the economy Nothing about GDP trend Inflation can create the illusion of GDP growth • Better working with real GDP (or GDP in volume) • T is the reference year (basis year) • Increase of RGDP can only come from an increase of QiT (hence the notion of GDP in volume) 11 Real GDP growth In practise, (R)GDP statistics are useless Use (R)GDP growth instead Remark: from now on, GDP = RGDP RGDP growth only means that the economy was able to produce more during a given period with respect to some previous period, not that production capacity increased • RGDP growth < 0 means recession while RGDP growth > 0 means economic expansion • Several possible measures • • • • – QoQ growth (% change wrt last quarter) – YoY growth (% change wrt same quarter previous year) – Annualized QoQ growth (% GDP growth for the entire year if growth remains constant; mostly used in the UK and in the US) 12 Economic growth Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 EZ GDP 1837.07 1856.82 1866.92 1882.34 1902.65 1911.28 1922.94 1929.34 1946.59 1943.1 1939.47 EZ GDP QoQ % 0.82 1.08 0.54 0.83 1.08 0.45 0.61 0.33 0.89 -0.18 -0.19 EZ GDP EZ GDP YoY % 1837.07 2.65 1856.82 3.01 1866.92 2.92 1882.34 3.30 1902.65 3.57 1911.28 2.93 1922.94 3.00 1929.34 2.50 1946.59 2.31 1943.1 1.66 1939.47 0.86 Source: Eurostat 13 QoQ and YoY growth measures are complementary 2.5 6 2 4 1.5 1 2 0.5 0 0 -0.5 -2 -1 -4 -1.5 -2 -6 90 92 94 96 98 00 US GDP QoQ % 02 04 06 08 10 US GDP YoY % Source: Macrobond Financial 14 Understanding growth • Need to disentangle – Structural determinants (long term) • Demography = extensive growth • Productivity = intensive growth – Conjuncture determinants (short term) • Inventories cycle • Investment cycle • Credit cycle • The economic system can be affected by shocks that can be of different types – Supply vs. demand – Domestic vs. external 15 Main challenge • Analysing economic growth poses one main challenge: differentiate the short term dynamics from the long term dynamics of growth • In other words, is a GDP drop/increase the sign – That GDP is below/above its trend? – Or rather the sign that it is the trend itself that has changed? • To do so, analysts rely on several indicators and not necessarily on growth statistics • Why? 16 Problem of lag • GDP statistics are available only on a quarterly basis • Furthermore, data releases come with a substantial delay • Final US Q2 GDP growth data will be published in late September 2018 • BEA: http://www.bea.gov • One quarter after the quarter in question ended • Predicting the past is useless • Other indicators are needed • Need to talk about leading indicators 17 Other indicators of economic activity • To have a “on time” measure of economic activity, other indicators must be used • “Hard” indicators measure real economic activity – Industrial production – Retail sales – Etc. • “Soft” indicators measure ‘economic’ sentiment – – – – – – Ifo (Europe) PMI (World) ISM (US) Consumer confidence (World) Outlook leading indicators (World) Etc. • Let’s see how this works 18 Industrial production and retail sales yearly growth vs. yearly GDP growth in the EZ 15 10 6 6 6 4 4 4 5 2 0 -5 0 -10 -20 -25 Jan-00 -2 -4 -6 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 2 0 -2 Last GDP (rhs) stat: t-3 Dernier pour le PIB: Lastchiffre IP stat: t-1Q1 Dernier chiffre pour la prod. Indus.: Avril -15 2 -4 -6 0 Last GDP (rhs) stat: t-3 Lastchiffre RSpour stat: t-1 Dernier le PIB: Q1 -2 -4 Dernier chiffre pour les ventes au détail.: Avril -8 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 -6 Jan-10 Source: Eurostat EZ Production industrielle (YoY %) • • • • EZ PIB (YoY %: rhs) EZ Ventes au détail (YoY %) EZ PIB (YoY %: rhs) Strong correlation between GDP and industrial production or retail sales IP and RS permit to assess the economic growth momentum at a given time… … and provide supply-side and demand-side information for economic activity IP and RS do have a direct economic interpretation 19 Ifo and consumer confidence vs. yearly GDP growth in the EZ 120 6 115 4 110 105 2 100 95 90 85 80 75 0 Last GDP (rhs) stat: t-3 Last Ifo stat: t-0 -2 Dernier chiffre pour le PIB: Q1 Dernier chiffre pour l'Ifo: Mai 70 Jan-00 -4 -6 Sep-01 May-03 Source: Eurostat Jan-05 Sep-06 Climat des affaires en Allemagne (Ifo) May-08 Jan-10 EZ PIB (YoY %: rhs) 5 6 0 4 -5 -10 2 -15 -20 -25 -30 -35 0 Last (rhs) t-3 DernierGDP chiffre pour le PIB:stat: Q1 Dernier chiffre pour la CC: Mai Last CC stat: t-0 -40 Jan-00 -2 -4 -6 Sep-01 May-03 Jan-05 Sep-06 Confiance des consommateurs May-08 Jan-10 EZ PIB (YoY %: rhs) • Ifo measures the “business climate” in the Eurozone and has a “current” and a “future” component • The “consumer confidence” index measures the “economic sentiment” and is made of several components (e.g. expected evolution of income, unemployment, buying intentions, etc.) • Ifo and CC permit to assess economic growth momentum (even though they can be biased) • Ifo and CC absolute values don’t have a direct economic interpretation 20 ISM & PMI vs. yearly GDP growth in the US 65 6 65 6 60 4 60 4 55 2 50 0 45 40 35 55 2 50 0 45 Last GDP (rhs) stat: t-3 Dernier chiffre pour le PIB: Q1 Dernier l'ISM: t-0 Mai Last chiffre ISMpour stat: 30 Jan-00 Sep-01 May-03 Jan-05 Sep-06 -2 May-08 Jan-10 Source: Macrobond Financial ISM manufacturier US PIB (YoY %: rhs) 40 Last GDP (rhs) stat: t-3 Dernier chiffre pour le PIB: Q1 Dernier PMI chiffre pour le PMI: Last stat: t-0Mai -4 35 -6 30 Jan-00 -2 -4 -6 Sep-01 May-03 Jan-05 PMI Composite Sep-06 May-08 Jan-10 EZ PIB (YoY %: rhs) • ISM and PMI are diffusion indices • Difference between positive and negative opinions of purchasing managers regarding the evolution of business in their respective sector • A value > 50 is consistent with economic expansion • A value < 50 is consistent with economic contraction 21 What about unemployment? 10,5 6 10 4 9,5 2 9 0 8,5 8 7,5 -2 GDP (rhs) EZ Unemployment rate 7 Jan-00 Source: Eurostat • • • -4 -6 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 The unemployment rate isdea chômage key economic indicator gives direct EZ Taux (%) EZ PIB (YoYand %: rhs) information concerning the state of the labour market However, it gives poor information regarding the current state of the economy The unemployment rate is rather seen as a lagging economic indicator 22 Wrapping up • Use soft indicators (leading indicators) to assess the economic outlook – Ifo or CC for July, August and September are already available and provide a good feeling of how well the economy performed during Q2 while the latest GDP data only concerns Q1 • Confirm conclusions with hard indicators (lagging indicators) – Look at IP or RS that are available up to August to confirm the conclusions provided by soft indicators • Never focus on one single point, rather use the evolution over several months or even quarters to capture the general trend followed by economic activity • What does this mean for corporates? 23 Section 2: Expectations and data Indicators and data • Elaborate an accurate view on economic growth and inflation is the ultimate objective of BCA • Several indicators are used by economic agents to make their opinion • Economic and financial data providers give useful information concerning this process • Following screens were obtained in Bloomberg 25 26 27 The role of surprises 28 Asymmetries • Since economic agents and markets are forwardlooking, economic/financial data surprises are important • Even more important in the presence of inefficient markets • Occur when actual data differs substantially from socalled market consensus • Surprises are big market movers even though their effect is not necessarily symmetrical • Economic agents react more to bad news than to equivalent-in-magnitude good news 29 Section 3: Inflation Consumer price index • • • • Inflation is the yearly growth of a consumer price index (CPI) Important to distinguish headline inflation from core inflation Headline inflation is usually more volatile This volatility comes mostly from specific components of the CPI such as energy prices 31 Headline inflation vs. core inflation 6 5 4 3 2 1 0 -1 -2 -3 J-96 US core inflation US headline inflation O-98 F-01 J-03 O-05 F-08 J-10 Source: Macrobond Financial US Inflation sous-jacente US inflation 32 Inflation and oil prices 33 Computing inflation 1/15/2007 2/15/2007 3/15/2007 4/15/2007 5/15/2007 6/15/2007 7/15/2007 8/15/2007 9/15/2007 10/15/2007 11/15/2007 12/15/2007 1/15/2008 2/15/2008 3/15/2008 4/15/2008 5/15/2008 6/15/2008 7/15/2008 8/15/2008 9/15/2008 10/15/2008 11/15/2008 12/15/2008 Source: Eurostat EZ CPI 102.51 102.81 103.5 104.15 104.4 104.5 104.25 104.31 104.71 105.22 105.78 106.2 105.8 106.17 107.21 107.55 108.23 108.64 108.47 108.32 108.52 108.55 108.02 107.88 EZ CPI MoM % -0.51 0.29 0.67 0.63 0.24 0.10 -0.24 0.06 0.38 0.49 0.53 0.40 -0.38 0.35 0.98 0.32 0.63 0.38 -0.16 -0.14 0.18 0.03 -0.49 -0.13 EZ CPI 102.51 102.81 103.5 104.15 104.4 104.5 104.25 104.31 104.71 105.22 105.78 106.2 105.8 106.17 107.21 107.55 108.23 108.64 108.47 108.32 108.52 108.55 108.02 107.88 EZ CPI YoY % 1.84 1.84 1.94 1.91 1.87 1.89 1.78 1.75 2.14 2.55 3.06 3.07 3.21 3.27 3.58 3.26 3.67 3.96 4.05 3.84 3.64 3.16 2.12 1.58 34 Inflation in the medium and long term • • • • • Oil prices can be used to predict inflation over the short term What about the medium and long term? “Inflation is always and everywhere a monetary phenomenon” (M. Friedman) Money base is a leading indicator for inflation This however is not an universal result and rather seems to hold in advanced economies only (particularly in the US and in Europe) 35 Money base vs. inflation 36 Inflation and the economic outlook • Inflation usually displays a tight link with the state of the labour market • Along these lines, inflation and economic activity have a strong relationship • This is summarised by the so-called Phillips curve 37 Inflation and employment 3.00 65 60 2.50 55 50 2.00 45 1.50 40 35 30 25 1.00 US core inflation US ISM employment index (lead 20y; rhs) 01 02 03 04 05 06 07 08 09 10 11 12 13 0.50 Source: Macrobond Financial 38 Inflation and unemployment 39 Phillips curve 40 Wrapping up • Overall, inflation can be caused by – Demand – Costs – Monetary conditions • Analysing inflation developments is key to understand competitiveness issues that is defined by the ratio of domestic prices to foreign prices • Inflation also matters for interest rates determination (see section 4) • What does this mean for corporates? 41 Section 4: Bond markets and interest rates Bond supply and demand • Interest rates are the result of supply and demand equilibrium on the bond market • Demand determinants – – – – Wealth & income (+) and propensity to save (+) Expected real (relative) return (+) Risk (-) Liquidity (+) • Supply determinants – Expected return on investment (+) – Expected inflation (+) – Fiscal policy (+) 43 Inflation vs. interest rates • When expected inflation rises, bond prices decrease… • … and interest rates increase • This is called the Fisher effect • Allows to understand why central banks most often focus on prices stability • Low inflation = low interest rates which are good for the economy P (é) i (ê) 44 Economic growth acceleration vs. interest rates • The theoretical impact of economic expansion on interest rates is undetermined • In practise, bond supply tends to increase more than bond demand • As a consequence, interest rates increase when economic activity is accelerating • This is not independent of the central bank action P (é) i (ê) 45 Risk structure of interest rates • Bonds with the same maturity can have different interest rates • Spreads can even vary accross time • This is explained by – Risk – Liquidity & fiscal rules US corp. BAA US corp. AAA US T-Bonds 15,5 13,5 11,5 Maturité: 10 ans 9,5 7,5 5,5 3,5 1,5 1983 10y maturity 1986 1989 1992 Source: Macrobond Financial US corp. AAA 1995 1998 2001 US corp. BAA 2004 2007 2010 US T-Bonds 46 Corporate spreads in Europe • Corporate spreads (= corp. – sov. bonds spread) = measure risk aversion 70 7 BBB credit spread in Europe 60 6 5 50 4 40 3 VDAX volatility index 30 2 20 10 1 2004 2005 2006 2007 2008 2009 2010 2011 2012 0 2013 Source: Macrobond Financial 47 Risk premium • A supply & demand analysis permits to rationalize the existence of a risk premium – If default risk associated to a given bond increases, the expected return of that bond decreases and demand for that bond drops – At the same time, the expected return of other bonds (whose associated default risk has remained unchanged) increases and demand for these bonds increase • As a consequence, the interest rate of the more risky bonds increases while the interest rate of the less risky bonds decreases • The difference is the risk premium 48 Explaining the risk premium with supply and demand P (é) i (ê) P (é) i (ê) Risk premium Market for risky bonds Market for risk-free bonds 49 Sovereign default risk • Corporate spreads reflect the difference of risk between a corporate bond and a sovereign • Within a given country, the sovereign bond yield usually corresponds to the risk-free rate • The idea is that no corporate can be less risky than the country in which it is established • What about inter-sovereigns risk? • Let’s consider the Eurozone case – Eurozone countries are not considered as displaying the same level of risk (e.g. German bund vs. Greek bonds) – The difference of risk is reflected by • • Debt ratings Bond yields spreads 50 Sovereign bond spreads in Europe Bond spreads can increase to reflect the risk associated to a given country. If spreads become to large, they can put the debt sustainability of a given country in danger 20 18 16 14 12 10 Greece Ireland Germany France 10y bonds Obligations d'Etat à 10 ans 8 6 4 2 J-01 D-02 J-04 D-05 J-07 D-08 J-10 Source: Eurostat Allemagne France Irlande Grèce 51 Term structure of interest rates • Interest rates of bonds having the same level of risk and submitted to the same fiscal rules can differ… • … due to differences of maturity • The yield curve summarizes this French gov. bonds 6 5 4 3 2 1 3m 5y 10y 0 J-97 Source: Eurostat J-99 Obligations d'Etat françaises J-01 J-03 3 mois J-05 5 ans J-07 J-09 J-11 10 ans 52 Understanding the yield curve • Bond yields are the sum of two components – Average of expected short term interest rates – Liquidity premium int = e it + it+1 +... + it+e (n−1) + Lnt n • First component necessary for the non-arbitrage condition to hold • Second component is a compensation for investors whose preferences are biased toward short term maturities 53 How to interpret the yield curve slope? i Strong interest rate growth expected (economic expansion) Maturity i Moderate interest rate growth expected (weak economic growth) Maturity 54 How to interpret the yield curve slope? i Moderate decrease or stability of interest rates is expected (economic stagnation) Maturity i Strong decrease of interest rates is expected (economic contraction) Maturity 55 Another way to look at the yield curve slope US 10 Y – US 2Y (bp) 350 300 250 200 150 100 50 0 -50 -100 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Source: Macrobond Financial • What does this mean for corporates? 56 Section 5: Stock markets Asset valuation and economic outlook • • • • Economic outlook influences corporates profits… … and their ability to pay dividends Assets prices equals the present value of future financial flows ke is the discount rate D1 Dn Pn P0 = +... + + n n 1+ ke 1+ k 1+ k ( e) ( e) 58 Gordon-Shapiro • Gordon-Shapiro is a model allowing to assess the impact of the economic outlook on assets prices – Pn (1+ ke ) n is omitted – Dividends grow at a constant rate g – Current asset price becomes P0 = D1 ke − g • Since ke and g are influenced by market rates and economic growth… • … the Gordon-Shapiro model provides powerful insights on the impact of economic outlook on stock markets 59 Monetary policy and stock markets • What is the impact of an interest rate cut on stock markets? – Policy rate cut leads to a decrease of short term rates and of bond yields – The discount rate ke in the economy decreases – Stock market prices increase • The story doesn’t end there… – Weaker interest rates lead to more investment, consumption and then to a stronger economic growth – Dividend growth rises, which also sustain stock markets 60 Market efficiency • Market efficiency – Can we forecast the evolution of financial markets? – Do they evolve with fundamentals ? • At High frequency, close to random walk • Does that mean that fundamentals are irrelevant? • Fundamentals are just information that eventually is incorporated in prices as long as markets are efficient 61 Absence of arbitrage • In efficient markets, there are no arbitrage opportunities = there is no opportunity to get profits with certainty • Earning money = taking risk, no free-lunch. • This derives from the uniqueness of prices in the framework of pure and perfect competition • In practise, arbitrage opportunities may exist (very) temporarily but financial agents called arbitragist drive prices to the equilibrium • Important to elaborate scenarios for g and k to foresee what potential developments of P0 can be • What does this mean for corporates? 62 Section 6: Forex Forex • Currencies relative prices (= exchange rate) are set on the foreign exchange market • Foreign exchange market is decentralized • Commercial and investment banks are the main players Source: Euromoney 64 The largest market in the world • Two markets usually monitored – Spot market = immediate delivery (our focus) – Forward market = future delivery (useful for hedging operations) • Daily turnover > $bn 1000 • Short term dynamics of exchange rates is difficult to predict à Interest rate parity condition (only interest rates matter) • Long term dynamics is easier to assess à Purchasing Power Parity theory (PPP) 65 Long term dynamics (5y or more) • Purchasing power parity theory (PPP) states that prices of two identical goods must not differ once expressed in the same currency • According to PPP, if prices increase by x% in a given country, the country’s currency must depreciate by x% • In the long term, the PPP is generally verified… • … even though important divergences can appear in the short or medium term 66 PPP 1.7 1.7 1.5 1.5 1.3 1.3 1.1 1.1 0.9 0.9 0.7 0.7 0.5 Jan-75 0.5 Jan-86 EUR/USD Jan-97 Jan-08 EUR/USD PPP Source: Macrobond Financial 67 Beyond prices • Other factors influencing exchange rates in the long term – Trade barriers – Productivity – Consumer preferences (foreign vs. domestic goods) – Etc. • It is possible to show that all these factors eventually reduce to a question of price! 68 Short term dynamics (up to 5y) • Long term determinants of exchange rates evolve rather slowly… • … while exchange rates can fluctuate rapidly in the short term • In the short term, only interest rates matter • Interest rates explain why investors hold one type of asset rather than another • This is reflected by the interest rate parity condition D i −i F E ( = e t+1 − Et ) Et 69 2-year spread and EUR/USD 2.50 1.60 Forecasting exchange rates is difficult but it is not necessarily the case of interest rates 2.00 1.50 1.00 1.55 1.50 1.45 0.50 1.40 0 1.35 -0.50 1.30 -1.00 1.25 -1.50 -2.00 2yr yield spread EUR - USD 2005 2006 2007 2008 1.20 EUR/USD 2009 2010 2011 1.15 Source: Macrobond Financial 70 Is it possible to reconcile the LT and ST dynamic of exchange rates? • Yes, through expectations • When agents expect exchange rates to depreciate/appreciate in the long term, exchanges rates will adapt immediately • The difficulty to build expectations on long term factors explain (partially) the important volatility of exchange rates observed in the short term • What does this mean for corporates? 71 Section 7: Fiscal and monetary policy Representing the economy • To understand government interventions and monetary policy, we need to formalize the economy • We rely on the IS/LM framework (short term, closed economy macroeconomic model) • IS (Investment and Savings) = equilibrium in the market of goods and services • LM (Liquidity preference and Money supply) = equilibrium in the money market 73 Equilibrium in the market of goods and services • IS is the solution of a system of 3 equations – Y = C + I + G (equilibrium) – C = C0 + c (Y − T ) (consumption equation) – I = I 0 − a (i − π e ) (investment equation) • System solution given by Y = C0 + cY − cT + I 0 − ai + aπ e + G • Or, solving for i C0 + I 0 + G − cT + aπ e (1− c) Y iIS = − a a 74 IS OA DA, Y DA1 DA2 45° Y i i2 i1 IS Y 75 Equilibrium in the money market • LM is the solution of a system of 2 equations s d – M = M (equilibrium) – M d = f (i,Y ) (money demand) – M s = M means that money supply is exogenous • Analytical solution requires assumptions regarding money demand • Linear demand often assumed: f (i,Y ) = M 0d + eY − hi • Solving for i yields iLM M 0d − M eY = + h h 76 LM ! %,!$&*$-" %,!#&*#-" !" " " " " !#" %'" ." " #" " !$" !" $" '+()" %&"'()" """"""""""""""""*$""""""""""*#"""""""""""""""""""*" 77 Economic policy interactions ! &'(! &'! &'! &'(! )*! )*(! !!!!!!!!!!"#!!!!!"$!!! &'! )*! )*! )*(! )*(! !!!!!!!!!!"#!!!!"$!!"%!! !!!!!!!!!!!!!!!!!!!!!!"!!! 78 Counter-cyclical stabilisation (fiscal policy) • Fiscal policy consists in controlling public expenditures and revenues • A discretionary rise of public expenditures coupled to a decrease of taxes is the usual authorities’ response in case of economic downturn • Automatic stabilizers also play a role – Social security spending increase when the economic activity decelerates – Collected taxes also decrease due to the fall of income 79 Multiplier effect • Y = GDP (expenditure approach) • Assuming that Y = C + I +G C = C0 + cY I = I0 • It arises that Y = C0 + cY + I 0 + G • It is then obvious to see that Y = m × (C0 + I 0 + G ) 1 m= ≥1 1− c • Useful to assess the impact of an increase of public expenditures on the economic output 80 Fiscal policy limits • To be efficient, fiscal policy must be sustainable in the long term • This supposes that recovery plans are financed by resources… • …accumulated in periods of strong economic growth • This is almost never the case 81 No fiscal deficits cycle! No!fiscal!deficits!cycle Source: The Economist and The European Commission www.unamur.be 53 82 Long term sustainability of public debt • Public debt is just the accumulation of past deficits • Structural fiscal deficits can put the long term sustainability of public debt in danger • Furthermore, fiscal policy decisions usually take a long time to be made • Raises the risk that fiscal policy is pro-cyclical (inefficient) rather than counter-cyclical 83 The risk of public debt Government debt (% GDP) Source: Eurostat 84 Monetary policy • Monetary policy focuses on policy rates… • … which are fixed in an attempt to control the evolution of market rates • The objective of most central banks is to ensure the stability of prices and to favour growth and employment • Monetary policy decisions are usually taken faster than fiscal policy measures • However, the impact of monetary policy materializes with a delay that can be of up to 24m 85 Economic downturn sequence of events 1. Economic downturn – Unemployment rises and consumption decreases, so as imports – Corporates are confronted to bad profit perspectives and reduce investments to avoid production overcapacity – Inventories decrease – If it is a global shock, exports also decrease 2. Authorities’ reaction – Recovery plan consisting in rising public expenditures to enhance the role of automatic stabilizers – Central bank cuts policy rate to pressure short and long term interest rates 3. Consequences – Public expenditures and weaker interest rates sustain national income and consumption and investment – Inflation and expected inflation rise – Lower interest rates lead to a domestic currency depreciation – Exports rise – Economic growth rebounds 86 What about the ECB? • • • • • The ECB’s principal objective is to ensure prices stability within the Eurozone Its mandate is much more restrictive than the Fed’s Inflation within the Eurozone has to remain between 0% and 2%... … in the medium term (allows for some tolerance vis-à-vis temporary inflationary shocks) Explicitly, the ECB is supposed to fight against deflation (big current threat) 87 Two pillars strategy 88 Policy rates • Three policy rates – Main refinancing rate (reference rate for refinancing operations) – Marginal lending facility rate – Deposit facility rate 89 Three policy rates 7 6 5 4 3 2 1 0 Jan-01 Jan-03 Refi Deposit facility rate Jan-05 Jan-07 Jan-09 Jan-11 Lending facility rate Source: ECB 90 Money market operations • The ECB determines its policy rates to influence market rates • The ECB also proceeds to regular refinancing operations aiming at providing European banks with necessary liquidity • Most important refinancing operations – Main refinancing operations are conducted on a weekly basis with a maturity of one week – Long term refinancing operations are conducted every month with a maturity of three months – Fine tuning operations – Structural operations 91 ECB’s Monetary policy implementation Source: ECB 92 Auction mechanism for MROs • Main refinancing operations take the form of an auction and are repurchase agreements • Every week, the ECB distributes a certain amount of liquidity to European banks (the amount is not public information) • Banks offer an interest rate that they are willing to pay to access to ECB’s funding • Once the auction is over, the ECB distributes the funds starting with the bank having proposed the higher interest rate • The ECB receives assets as collateral (usually government bonds) • In normal circumstances, all banks participating to the auction are not ensured to get funding • During the financial crisis, the ECB replaced the auction mechanism with a fixed rate tender mechanism with full allotment, it also decreased the minimum rating requirement for collaterals 93 Money market • ECB’s refinancing operations are complementary to refinancing operations that occur autonomously on the money market • Lending and deposit facility are meant to be only marginal • Main money market rates (not fixed by the ECB) – EONIA (overnight) – Euribor 3m 94 Policy rates vs. money market rates 95 To sum up Source: ECB 96 Section 8: Putting it all together Real vs. financial economy • Tight links between both parts of the economy – Stock prices depend upon future profits that are themselves influenced by economic activity – Stock market developments impact corporates investment decisions and households consumption decisions – A real shock can be amplified by financial markets – Financial shocks can transmit to the real economy 98 Real vs. financial economy • Authorities also play a central role – Central banks policy rates are key for elaborating portfolios and hedging strategies – Some financial variables can help predicting economic activity developments 99 Real vs. financial economy 100 Fiscal deficit and long term yields • Deficit à Creation of debt à Bond prices decrease and bond yields increase à Sovereign risk potentially rises à Risk premium rises • In periods of stress, this mechanism might not work if bond demand is strong (safe heaven) • In that case, the creation of debt will not necessarily translate into higher sovereign bond yields • This would only hold as long as there are no concerns regarding the debt sustainability 101 Stock markets and bond yields • Consider that stock markets prices rise à Bonds become relatively less interesting à Bond prices drop and interest rates increase • Consider that stock market prices decrease à Bonds become relatively more interesting à Bond prices increase and interest rates decrease à “Flight to quality” 102 Flight to quality 1300 5.5 1200 5 1100 4.5 1000 4 900 3.5 800 3 700 600 2.5 500 2 Jun-07 Sep-07 Dec-07 Mar-08 MSCI Jun-08 Sep-08 Dec-08 US bond 10y yield EZ bond 10y yield Source: Macrobond Financial 103 Inflation and bond yields • Inflation expectations rise à Bond issuances increase because the real cost of borrowing decreases à Nominal long term yields increases • But long term interest rates also are influenced by short term rates à Long term interest rates = chain of short term rates à Rising short term rates lead to higher long term rates • Other factors can reinforce or weaken this mechanism – Inflation – Growth – Risk premium – Uncertainty – Etc. 104 A dashboard GDP Inflation Forex Euribor 3m 10y yield Stock Q4 2016 0.3 0.2 1.09 -0.12 0.99 4637 Q1 2017 0.6 -0.1 1.14 -0.22 0.41 4385 Q2 2017 -0.1 0.2 1.11 -0.27 0.20 4237 Q3 2017 0.7 0.3 1.12 -0.30 0.12 4448 Q4 2017 0.5 0.6 1.05 -0.32 0.68 4862 Q1 2018 0.5 1.1 1.07 -0.33 0.97 5122 Q2 2018 0.5 0.7 1.14 -0.33 0.82 5120 ↑ ↑ ↑ = = = ↑ 2 consecutive quarters of growth ↓ 2 consecutive quarters of decline = 1 quarter of growth and 1 quarter of decline or no evolution 105 Conclusion • • • • • • • • Macroeconomics is important to financial markets Several financial variables depend upon macroeconomic developments Understanding economic mechanisms is key to understand the environment in which our business evolves Don’t forget though that it is a two-way relationship Financial markets are forward looking and rely heavily upon expectations Expectations are key to underestand market movements Building up your own opinion and expectations on a given topic is fundamental But don’t forget that the market consensus is also very important (even though it is not always based on rational elements) 106