5. CME: Economic Forecasting

4.6.3. Defaultable Debt o. *Demonstrate the use of economic information in forecasting asset class returns*

Debt w/ some meaningful amount of credit risk—in particular, most CORPORATE DEBT. • For corporate debt, such as CERT. OF DEPOSIT & bonds, the spread over Treasuries represents at least in part the market's perception of default risk. • INDIVIDUAL SECURITY move in response to particular corporate circumstances, but the MARKET AS A WHOLE responds primarily to changes in ST rates and changes in the BUSINESS CYCLE. 1. During a business cycle, SPREADS RISE during a RECESSION because companies are under STRESS from both weak business conditions and, typically, higher interest rates. • Sometimes, borrowing from banks or in the commercial paper market becomes more difficult too, so that companies can be severely squeezed. • Default rates typically rise during recessions. Investors demand higher rates to pay for the uncertainties and possible surprises, such as fraud. 2. During STRONG ECONOMIC GROWTH, SPREADS NARROW as fears of default decline.

4.6.6.2. The P/E Ratio and the Business Cycle

During the business cycle, the P/E ratio tends to be high and rising when earnings are expected to rise. • P/E would be HIGH in the early stages of an economic recovery, or when IR are LOW & the return on fixed-rate investments such as cash or bonds is less attractive. • P/Es are likely to be LOW and falling if the outlook for earnings worsens (e.g., in an economic slump). • P/Es of CYCLICAL companies may be ABOVE their own historical MEAN during economic DOWNTURNS as investors anticipate a sharp future earnings RECOVERY when the economy turns up (a phenomenon known as the MOLODOVSKY effect). HIGH INFLATION rates tend to DEPRESS P/E ratios. Inflation can distort the economic meaning of reported earnings, leading investors to value a given amount of reported earnings less during inflationary periods, which tends to LOWER P/Es during those periods. Comparisons of CURRENT P/E w/ past avg P/E that do not control for diff in inflation rates may be suspect.

4.5.1. Econometric Modeling ADVANTAGES AND LIMITATIONS n. *Compare the major approaches to economic forecasting*

Econometrics: quantitative modeling and analysis grounded in economic theory to the analysis of economic data. Econometric models are widely regarded as very useful for SIMULATING THE EFFECTS of changes in certain variables. For example: 1. Useful for assessing the impact of a 10% rise in oil prices 2. Rise in income tax rates 3. Faster growth rate in trading partners on consumer demand Econometric models have several LIMITATIONS. 1. Require the user to find adequate measures for the real-world activities & relationships to be modeled, and these measures may not be available. 2. Variables may also be measured with error. 3. Relationships among the variables may change over time because of changes in the structure of the economy; as a result, the econometric model of the economy may be misspecified. In practice, therefore, skillful econometric modelers use a great deal of personal judgment in arriving at forecasts. First run of the model will generate a forecast that the modelers do not believe. So, they will go back and change some of the exogenous variables to arrive at a forecast they do believe. Great merit of this approach is that it constrains the forecaster to a certain degree of consistency & also challenges the modeler to reassess prior views based on what the model concludes. In practice, model-based forecasts RARELY forecast RECESSIONS well, although they have a better record in ANTICIPATING UPTURNS.

4.5.2. Economic Indicators n. *Compare the major approaches to economic forecasting*

Economic indicators are economic statistics provided by government and established private organizations that contain information on an economy's recent past activity or its current or future position in the business cycle. • LAGGING economic indicators and coincident indicators are indicators of recent past and current economic activity • A LEADING economic indicator (LEI) is a variable that varies with the business cycle but at a fairly consistent time interval before a turn in the business cycle. ADVANTAGES: 1. provide info about upcoming changes in economic activity, inflation, interest rates, and security prices. 2. Leading indicator-based analysis is the simplest forecasting approach to use because it requires following only a limited number of variables. The indicators are best thought of as early signs of probable events to come. Analysts may use both individual LEIs and composite LEIs, reflecting a collection of economic data releases that are combined to give an overall reading. Composite LEIs combine these releases using weights based on an analysis of their forecasting usefulness in past cycles. Can also be combined in a DIFFUSION index, which measures how many indicators are pointing UP and how many DOWN. General rule was that THREE consecutive months of INCREASES, or THREE consecutive months of DECREASES, signaled an upturn or downturn in the economy within three to six months.

4.6.6.3. Emerging Market Equities

Empirical evidence points to ex post equity risk premiums for emerging markets that are on AVG HIGHER & more VOLATILE than those in DEV MKTS. Ex post, EM equity risk premiums in USD terms appear to be POSITIVELY correlated with EXPANSION phases in G-7 economies as proxied by INDUSTRIAL PRODUCTION. Transmission channels for G-7 macroeconomic fluctuations to developing economies include trade (demand for many of the goods produced by emerging countries, such as natural resources, is procyclical), finance, and direct sectoral linkages. In addition to evaluating linkages, the analyst needs to do considerable country and often sector-specific research to appraise the prospects for equity investments in a particular emerging country.

4.6.2. Nominal Default-Free Bonds o. *Demonstrate the use of economic information in forecasting asset class returns*

For investors buying & selling long-term bonds over a shorter time period, the emphasis is on how bond yields will respond to developments in the business cycle and changes in short-term interest rates. News of stronger economic growth usually makes bond yields rise (prices fall):Because it implies greater demand for capital and perhaps higher inflation too. Changes in ST rates have less predictable effects on bond YLDS: • RISE in ST rates will lead to a RISE in LT bond yields • RISE in rates will sometimes be expected to slow the economy, and bond yields could fall as a result. • If bond markets expect that CB will exactly achieve their inflation objectives, then bond yields SHOULD NOT CHANGE on inflation expectations but nevertheless could go UP and DOWN according to changes in SHORT RATES(with higher short rates making bonds less attractive in relative terms). As bond investors look toward the long-term picture, they must carefully assess the future effects of inflation, which erodes the future purchasing power of the yields earned on their fixed-income investments.

WHY THE YIELD ON INDEXED BONDS CHANGE OVER TIME: 3 FACTORS

However, the yield on indexed bonds still changes over time, and in practice it varies with three economic factors. 1. The yield goes up and down with the real economy and particularly with the level of ST IR. If real yields generally are HIGH because the economy is strong, then real yields on TIPS and ILGs will be HIGHER. 2. Yield FALL if INFLATION ACCELERATES because these securities are more attractive when inflation is volatile. Their value in hedging against inflation risk is HIGHER. 3. The yield can vary according to institutional supply and demand. In practice, tax effects and the limited size of the market (particularly for TIPS in the United States) may also distort the real yield; thus, investors usually find it worthwhile to forecast all three components (real yield, inflation, and supply and demand).

4.6.6.1. Economic Factors Affecting Earnings

In the LT, the trend growth in aggregate company earnings is mainly determined by the trend rate of growth of the economy. • A faster-growing economy is likely to show FASTER avg earnings growth, while a SLOWER economy is correlated with SLOWER earnings growth. • The trend rate of growth of an economy is dependent on labor force growth, the level of investment, and the rate of labor productivity growth. • Variations in growth rates among countries are usually due to past over investment, government over regulation or political instability, or the bursting of a major asset price bubble. Over the ST, the share of profits in GDP varies with the BUSINESS CYCLE and is influenced by a variety of factors, including final sales, wages, capacity utilization, and interest rates.

4.6.1. Cash and Equivalents o. *Demonstrate the use of economic information in forecasting asset class returns*

Make money through selection of the MATURITY of the paper in their portfolio or, if permitted by taking CREDIT RISK. • LONGER maturities & LOWER CREDIT RATINGS reward the EXTRA RISK with HIGHER EXP. RET. • Managers LENGTHEN or SHORTEN maturities according to their expectations of where IR will go next. • LONGER-maturity paper will pay a HIGHER IR than SHORTER-maturity paper, even if overnight IR are expected to remain the SAME, because the risk of loss is greater for the longer-term paper if this expectation is not fulfilled. • If FURTHER RISES in rates are expected over time, then 6- & 12MO paper should offer EVEN HIGHER rates than shorter-term paper. OVERNIGHT IR is targeted by the CB & will normally vary only slightly from the target set. YLD curve of IR of a particular security (e.g., Treasury bill) reflects the MKT's expectations of rates over that period. The money manager is trying to be ahead of others in correctly forecasting those levels. In practice, this means forecasting both the behavior of the economy and the reaction of the CB to that behavior. It also means understanding what the mkts currently anticipate & distinguishing between future data surprises and what is already factored into expectations. Thus managers spend a lot of time in so-called "central bank watching."

4.6.5. Inflation-Indexed Bonds o. *Demonstrate the use of economic information in forecasting asset class returns*

Many governments now issue bonds linked to inflation, so in principle, we can directly observe the market's forecast of inflation by comparing the yield of these indexed bonds with the yield on similarly dated conventional bonds. Examples: 1. TIPS IN THE US. 2. Index-Linked Gilts (ILGs) IN THE UK These provide a fixed coupon (the real portion) plus an adjustment equal to the change in consumer prices. In principle, indexed bonds are the perfect risk-free asset because, unlike conventional bonds, they entail no risk from unexpected inflation.

4.6. Using Economic Information in Forecasting Asset Class Returns o. *Demonstrate the use of economic information in forecasting asset class returns*

Movements in economic variables play a key role in forming investors' expectations. Although some investors, such as pure bottom-up stock pickers or fully hedged arbitrage specialists, do not care much about the way that economic developments move markets, it is important for most investors. In this section, we look at how the principal asset classes are moved by different economic variables.

4.6.2. Nominal Default-Free Bonds o. *Demonstrate the use of economic information in forecasting asset class returns*

Nominal default-free bonds are conventional bonds that have no (or minimal) default risk (Conventional government bonds of developed countries) Thus, our focus is on the government yield curve. • One way to think of the yield on a government bond is that it reflects the expected future short-term Treasury bill yields over the same horizon. • Another approach, which is more useful for longer-term bonds, is to break down the yield into at least two components: o First, the so-called real bond yield is determined by the growth rate of GDP and the supply and demand for capital. o Second, yields are affected by forecast inflation over the investment period. For default-risk-free bonds, the credit spread or default risk premium is ZERO. Investors may thus assess whether bonds are cheap or expensive according to their view on whether the markets are too optimistic or too pessimistic based on real yields and inflation.

4.6.4. Emerging Market Bonds o. *Demonstrate the use of economic information in forecasting asset class returns*

Sovereign debt of non-developed countries • EM bonds are different in that the country is borrowing in a foreign currency. • The government therefore cannot simply inflate its way out of a problem in servicing the debt, and so the risk of default is correspondingly higher. • Assessing this risk, using what is known as country risk analysis, involves a large array of economic and political factors. • Much of country risk analysis comes down to predicting policy moves and therefore often hinges on politics—that is, whether a government has the power to follow the necessary policies to stabilize the economy. • EM bonds are usually analyzed by developed market investors in terms of their SPREAD OVER DOMESTIC TREASURIES compared to similarly rated domestic corporate debt.

4.6.7. Real Estate o. *Demonstrate the use of economic information in forecasting asset class returns*

Systematic determinants of real estate returns: 1. growth in consumption, 2. real interest rates, 3. the term structure of interest rates, and 4. unexpected inflation IR are linked with a number of factors that affect the supply & demand for RE such as construction financing costs and the costs of mortgage financing. In general, LOWER IR are net POSITIVE for RE VALUATION, resulting in LOWER CAPITALIZATION RATES.

4.6.6. Common Shares o. *Demonstrate the use of economic information in forecasting asset class returns*

To relate economic analysis to common equity valuation, it is useful to think of economic factors, 1. In the way that they affect company earnings 2. In the way that they affect interest rates, bond yields, and liquidity. The two views combined provide a forecast for the equity markets and can lead to new investor ideas and trading activity. Particular economic factors will also affect the outlook for specific companies—for example, the price of oil or the demand for airline travel. Here, we focus on the impact on the overall stock market.

4.5. Economic Forecasting n. *Compare the major approaches to economic forecasting*

We can now indicate some of the disciplines that the analyst can apply to economic forecasting. We may distinguish at least three distinct approaches: 1. ECONOMETRIC MODELS: The most formal and mathematical approach to economic forecasting 2. LEADING INDICATORS: Variables that have been found to lead (precede) turns in the economy 3. CHECKLISTS: Requiring the subjective integration of the answers to a set of relevant questions.

p. Evaluate how economic and competitive factors affect investment markets, sectors, and specific securities

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4.5.3. Checklist Approach n. *Compare the major approaches to economic forecasting*

• Consider a whole range of economic data to assess the future position of the economy. ADVANTAGES: • Straightforward but time-consuming because they require looking at the widest possible range of data. • The data may then be extrapolated into forecasts via objective statistical methods, such as time-series analysis, or via more subjective or judgmental means. • An analyst may then assess whether the measures are in an equilibrium state or nearer to an extreme reading. • In effect, the forecaster asks a series of questions about likely components of spending and then, aggregating the information gathered, reaches a conclusion about the outlook for the economy. • Such an approach involves a substantial amount of SUBJECTIVE judgment as to what is important in the economy.