Dr. Vasco
Vendrame
Financial Investments in
Practice
(UMADEQ-15-M)
Macroeconomic and Industry Analysis
Outline of the lecture
• The macroeconomy (global and domestic)
 Key economic statistics
• Demand and supply shocks
• Fiscal and monetary policy
• The business cycles
• Economic indicators
• Industry analysis:
 Define an industry
 Sensitivity of industries to the business cycle
 Industry life cycles, structure and performance
Introduction
• Intrinsic value of a stock depends on the dividend and
earnings that can be expected from the firm
• Fundamental analysis is an assessment of firm value that
focuses on such determinants as the following:
• Earnings an dividends prospects
However, fundamentals are tied to the economy
The Global Economy
• Exchange rate
 The rate at which domestic currency can be converted into
foreign currency.
 Affects the international competitiveness of the country.
 The depreciation of domestic currency makes the
domestic products cheaper in foreign countries and
increases the exports and hence the GDP growth.
The Global Economy (Continued)
• International economy affects various aspects of a firm’s
prospects
• Export prospects
• Price competition it faces from competitors
• Profits it makes on investments abroad
• Performance in countries and regions can be highly variable
• Harder for businesses to succeed in contracting economies
than in expanding ones
Economic Performance
• Table 17.1 Economic performance, 2018
Stock market Return, 2018 (%)
In Local Currency
In U.S. Dollars
GDP growth (%)
Brazil
19.1
1.9
1.3
Britain
−12.4
−17.9
1.5
Canada
−11.5
−18.7
1.5
China
25.5
−29.3
6.5
France
11.7
−16.7
1.4
Germany
18.1
−22.8
1.2
−16.0
−16.1
2.9
India
5.4
−4.6
7.1
Italy
−16.1
−20.9
0.7
Japan
12.1
9.8
0.0
Mexico
−14.4
−14.7
2.5
Russia
−7.6
−22.7
1.5
Singapore
−10.7
−13.3
2.2
South Korea
−18.5
−22.7
2.0
Spain
−14.9
−19.8
2.5
−6.1
−6.1
3.0
Hong Kong
U.S.
• Source: The Economist, January 5, 2019.
The Global Economy (Continued)
• Political uncertainty can pose considerable economic risks
• Sovereign debt crisis
• Brexit
• Russian war?
• An exchange rate is the rate at which domestic currency
can be converted into foreign currency
• In early 2019, it took about 110 Japanese yen to
purchase 1 U.S. dollar
• Exchange rate is $0.0091 per yen
The Domestic Macroeconomy
• The macroeconomy is the environment in which all firms
operate.
• Stock prices tend to rise with earnings
• P/E ratios tend to be in the range of 12 to 25
• Forecasting the performance of the broad market begins
with an assessment of the economy as a whole
The Domestic Macroeconomy: Key Economic Indicators
• Objective: describe the state of the economy
 Gross domestic product (GDP)
 Employment
• Measured via unemployment rate
 Inflation
 Interest rates
 Budget deficit
 Sentiment
The Domestic Macroeconomy (Continued)
 Gross Domestic Product (GDP)
– The measure of the economy’s total production of goods and
services.
– Rapid growth in GDP indicates an expanding economy and
higher sales for the firms.
– Industrial production (IP): another measure of total output. It
focuses on the manufacturing side of the economy.
 Employment
– Unemployment rate=number of those who are not working/total
labor force (people who are either working or actively seeking
employment)
– Measures the extent to which the economy is operating at full
capacity.
The Domestic Macroeconomy (Continued)
 Inflation
– The rate at which the general level of prices rise.
– High rates of inflation are associated with overheated
economies.
– There is a trade-off between inflation and unemployment.
 Interest Rates
– Determinant for business investment expenditures.
– As interest rates increases the investment decreases so
does the economic growth.
The Domestic Macroeconomy (Continued)
 Budget Deficit
– The difference between government spending and
revenues.
– The deficit should be closed by borrowing.
– The government borrowing can increase interest rates and
crowd-out the private borrowing and decrease investment
and affect economic growth negatively.
 Sentiment
– Beliefs (optimism and pessimism) of consumers and
producers influence the levels of consumption and
production and affect the aggregate demand for goods and
services.
Demand and Supply Shocks
 Demand shock
– An event that affects the demand for goods and services in
the economy.
– Examples for positive demand shocks: reduction in tax
rates, increase in money supply, increases in government
spending, increases in foreign exports.
– Usually characterized by aggregate output moving in the
same direction as interest rates and inflation.
Demand and Supply Shocks (Continued)
 Supply shock
– An event that influences production capacity and costs.
– Examples of supply shocks: changes in prices of
intermediate goods such as oil, changes in the education
level of an economy’s workforce or changes in the wage rate.
– Supply shocks cause the aggregate output move in the
opposite direction of inflation and interest rates.
Federal Government Policy
• Demand-side policy has been of primary interest for much
of postwar history
• Focus on increasing demand for goods/services
• For example, government spending, taxes, and
monetary policy
• Supply-side economics has been gaining attention since
the 1980s
• Focus on enhancing productive capacity of the economy
• For example, national policies on education,
infrastructure, and research and development
Fiscal Policy
• How can government affect the demand and supply of
goods and services?
• Fiscal policy is the use of government spending and
taxation for the specific purpose of stabilizing the economy
• Most direct way to either stimulate or slow the economy
• Decrease in government spending decrease the demand for
goods and services while increase in tax rates decrease the
income of consumers (households).
– If budget deficit>0 then government spend more than it
earns and stimulate the economy.
• Formulation of fiscal policy is often a slow, cumbersome
political process
Monetary Policy
• Actions taken by the Board of Governors of the Federal
Reserve System to influence the money supply or interest
rates is referred to as monetary policy
• Increasing the money supply lowers short-term interest
rates, which encourages investment and consumption
demand
• Less immediate effect than fiscal policy
Monetary Policy (Continued)
• Tools of monetary policy
 Changing monetary base ( consists of currency and
banks’ deposits in the central bank) by open market
operations
• Fed buys/sells bonds for its own account
 Changing the discount rate
• Interest rate the Fed charges banks on short-term loans
• Reductions in discount rate signal a more expansionary
monetary policy
 Changing the required Reserve ratio, the fraction of
deposits banks have to keep in the CB.
• Lowering requirements allows banks to make more
loans with each dollar of deposits and stimulates the
economy by increasing the effective money supply
Supply-Side Policies
• Goal is to create an environment in which workers and
owners of capital have the maximum incentive and means
to produce and develop goods
• Supply-siders focus on how tax policy can improve
incentives to work and investment
The Business Cycle
Business Cycle:
– The recurring pattern of recession and recovery.
– The economy recurrently experiences periods of expansion
and contraction but the length and depth of those cycles can
be different.
– The transition points across cycles are called peaks and
troughs
• A peak is the transition from the end of an expansion to the
start of a contraction
• A trough occurs at the bottom of a recession just as the
economy enters a recovery
The Business Cycle (Continued)
• Cyclical Industries
• Above-average sensitivity to
the state of the economy
• For example, producers of
durable goods, such as
automobiles
• High betas
• Defensive Industries
• Little sensitivity to the
business cycle
• Examples
• Food producers and
processors
• Pharmaceutical firms,
• Public utilities
• Low betas
Economic Indicators
Set of cyclical indicators helps to forecast, measure, and interpret
short-term fluctuations in economic activity.
– These indicators can be divided into three general groups as
leading, coincident and lagging.
 Leading indicators tend to rise and fall in advance of the
economy.
• Examples: average weekly hours of production workers, stock
prices
 Coincident indicators tend to change directly with the economy
• Examples: industrial production, manufacturing and trade sales
 Lagging indicators tend to follow the lag economic
performance.
• Examples: ratio of trade inventories to sales
Economic Indicators
• Table 17.2 Indexes of economic
indicators
• Source: The Conference
Board, Business Cycle
Indicators, March 2019.
A
Leading Indicators
1
Average weekly hours of production workers (manufacturing)
2
Initial claims for unemployment insurance
3
Manufacturers’ new orders (consumer goods and materials industries)
4
Institute of Supply Management’s “Index of New Orders”
5
New orders for nondefense capital goods
6
New private housing units authorized by local building permits
7
Yield curve slope: 10-year Treasury minus federal funds rate
8
Stock prices, 500 common stocks
9
Leading index of credit market conditions
10
Index of consumer expectations for business conditions
B
Coincident Indicators
1
Employees on nonagricultural payrolls
2
Personal income less transfer payments
3
Industrial production
4
Manufacturing and trade sales
C
Lagging Indicators
1
Average duration of unemployment
2
Ratio of manufacturing and trade inventories to sales
3
Change in index of labor cost per unit of output
4
Average prime rate charged by banks
5
Commercial and industrial loans outstanding
6
Ratio of consumer installment credit outstanding to personal income
7
Change in consumer price index for services
Indexes of Indicators
• Figure 17.3 Indexes of leading and coincident lagging indicators
• Note: Shaded areas represent recessions.
• Source: The Conference Board, News Release, February 21, 2019.
•
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Economic Calendar
Date
Statistic
For Period
Actual
Briefing
Forecast
Feb 26
Housing starts
Dec 2018
1.078 million
1.256 million
Feb 26
Consumer confidence
Feb 2018
131.4
124.7
Feb 27
Factory orders
Dec 2018
0.1%
0.5%
Feb 28
Jobless claims
Week of Feb 23
225,000
225,000
Feb 28
GDP
2018, Q4
2.6%
1.9%
Mar 1
Personal income
Jan 2019
-0.1%
0.3%
Mar 1
Consumer spending
Jan 2019
-0.5%
-0.4%
Mar 1
Core inflation
Dec 2018
0.2%
0.2%
Mar 1
ISM manuf index
Feb 2019
54.2%
55.5%
• Figure 17.4 Excerpt of economic calendar, week of February 25, 2019
• Source: www.marketwatch.com/tools/calendars/economic, March 1, 2019.
Industry Analysis
• Just as it is difficult for an industry to perform well when the
macroeconomy is ailing, it is unusual for a firm in a troubled
industry to perform well
• Economic performance can vary widely across industries
Return on Equity by Industry
• Figure 17.5 Return on equity by industry, 2018
• Source: Professor Aswath Damadaran, http://pages.stern.nyu.edu/~adamodar/.
•
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Industry Stock Price Performance
• Figure 17.6 Industry stock price performance, 2018
• Source: Authors’ calculations using data from Prof. Kenneth French’s Web site,
http://mba.tuck.dartmouth.edu/pages/ faculty/ken.french/Data_Library.
•
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Defining an Industry
• North American Industry Classification System, or NAICS
codes, are codes assigned to group firms for statistical
analysis
• Firms with the same four-digit NAICS codes are commonly
taken to be in the same industry
• First 2 digit denotes very broad industry classification and
the next digits define the industry grouping narrowly.
Examples of NAICS Industry Codes
• Table 17.5 Examples of NAICS industry codes
NAICS Code
NAICS Title
23
Construction
236
2361
Construction of Buildings
Residential Building Construction
23611
Residential Building Construction
236115
New Single-Family Housing Construction
236116
New Multifamily Housing Construction
236118
Residential Remodelers
2362
Nonresidential Building Construction
23621
Industrial Building Construction
23622
Commercial and Institutional Building Construction
Sensitivity to the Business Cycle
• Three factors decide the sensitivity of a firm’s earnings to
the business cycle: sensitivity of sales of the firm’s
product to the business cycles, operating leverage,
financial leverage.
 Sensitivity of sales
• Necessities such as foods, drugs, and medical services will
show little sensitivity to business conditions.
• Firms in the industries such as steel, auto, and
transportation are highly sensitive to the state of the
economy.
Industry Cyclicality
• Figure 17.8 Industry cyclicality: Growth of sales, year over year, in two industries; sales
of jewelry show much greater variation than sales of groceries
• Source: U.S. Census Bureau.
•
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Sensitivity to the Business Cycle (Continued)
 Operating leverage
• Refers to division between fixed and variable costs
• Profits of firms with greater variable costs (that is, low
operating leverage) will be less sensitive to business
conditions
• Profits for firms with high fixed costs (that is, high
operating leverage) will swing more widely with sales
• Firms with high fixed costs are said to have high
operating leverage because small changes in business
conditions may have large impacts on profitability.
Sensitivity to the Business Cycle (Continued)
• In order to quantify the operating leverage:
• Degree of operating leverage (DOL)=percentage change in
profits/percentage change in sales.
• DOL=1+(Fixed costs/profits)
 Financial Leverage
• The use of borrowing. (Total debt/total equity)
• The interest payments on debt is a fixed costs and
increases the sensitivity of the firms to the changes in the
business cycle.
Operating Leverage of Firms A and B Throughout
Business Cycle
Recession
Normal
A
Sales (million units)
B
B
A
B
5
6
6
7
2
$ 2
$ 2
$ 2
10
10
12
12
14
14
Fixed costs ($ million)
5
8
5
8
5
8
Variable costs ($ million)
5
2.5
6
3
7
3.5
Total costs ($ million)
$10
$10.5
$11
$11
$12
$11.5
Profits
$ 0
$(0.5)
$ 1
$ 1
$ 2
$ 2.5
Price per unit
Revenue ($ million)
5
A
Expansion
$ 2
$
7
$
2
A Stylized Depiction of the Business Cycle
Sector rotation is an investment strategy which entails shifting the
portfolio into industry sectors that are forecast to outperform others based
on macroeconomic forecasts
•
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Sector Rotation
• Peaks – the economy might be overheated with high
inflation and interest rates
– Time to invest in natural resource extraction firms, minerals
and petroleum
• Contraction (recession) – the economy is getting smaller
– Time to invest in defensive industries such as
pharmaceuticals and food
• Trough – the economy is ready to recover, and then
expand.
– Time to invest in capital goods industries, such as
equipment, transportation or construction.
• Expansion – the economy is growing
• – Time to invest in cyclical industries such as consumer
durables and luxury items
Sector Rotation
• Figure 17.10 Sector rotation
• Source: Sam Stovall, BusinessWeek Online, “A Cyclical Take on Performance.”
•
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Industry Life Cycles
• The industry life cycle might be described as four stages:
 Start-up stage: characterized by extremely rapid growth
of sales and earnings
• Early stages of an industry
• New technology
• Difficult to predict which firms are going to be leaders.
• Some will be very successful some will fail
Industry Life Cycles (continued)
 Consolidation stage: characterized by growth that is less
rapid but still faster than the general economy
• Industry leaders begin to emerge
• Survivors from the start-up stage are more stable and the
performance of the survivors closely track the performance
of the industry
 Maturity stage: characterized by the growth no faster than
the general economy
• The product has reached its full potential for use by the
consumers.
• Producers compete on the basis of price
• Narrow profit margins
Industry Life Cycles (continued)
 Relative decline stage: characterized by the growth less
rapidly than the rest of the economy
• The product become obsolete
• Competition from new low-cost suppliers (or new products)
• Generally industries at the high-growth stages are more
attractive for investment unless the stock prices already
reflects likelihood for high growth.
The Industry Life Cycle
•
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Industry Structure and Performance: Five Determinants
of Competition
1.
2.
3.
4.
5.
Threat of entry
Rivalry between existing competitors
Pressure from substitute products
Bargaining power of buyers
Bargaining power of suppliers
Industry Structure and Performance: Five Determinants
of Competition (Continued)
• Industry Structure and Performance
– Porter’s (1985) determinants of competition
 Threat of entry
– High prices and profit margins will encourage entry by new
competitors.
– Barriers to entry is a key determinant of industry profitability
 Secure distribution channels
 Brand loyalty
 Patent protection
 Experience in the market
Industry Structure and Performance: Five Determinants
of Competition (Continued)
 Rivalry between existing competitors
– More price competition and lower profit margin
– Factors that affect the rivalry
 Slow industry growth
 High fixed costs
 Homogeneous products
 Pressure from substitute products
– Availability of substitutes limits the prices that can be
charged.
Industry Structure and Performance: Five Determinants
of Competition (Continued)
 Bargaining power of buyers
– If a buyer purchases a large fraction of an industry’s output,
it will have considerable bargaining power and ask for price
reductions and reduces the profitability of the supplier.
 Bargaining power of suppliers
– If a supplier of a key input has monopolistic control over the
product, it can demand higher prices for the good and
decrease the profits of the industry.
References
Bodie, Kane, Marcus. Investments, 2021. 12th Edition.
McGraw Hill. (Chapter 17)
47