Financial Education

Major movements in interest rates, equities and commodity prices are related to changes in the business cycle.

Typically, the bond market is the first to signal business cycle turning points. Bonds will begin a bull phase after economic growth has slowed considerably, and often during the early stages of a recession. Bond prices are inversely related to interest rates, so falling interest rates result in higher bond prices.

As the recession deepens, equity investors begin to “look past” the trough in corporate profits. As a general rule, the longer bonds have been rallying prior to the bottom in the stock market, the better the chances of a rally in stocks.

Once the recovery begins, resource utilization begins to tighten and commodity prices bottom.

Cash

Cash managers can earn higher returns by accepting longer-dated maturities or credit risk. The yield curve reflects the consensus expectation for future interest rates. Managers must distinguish between future events that are reflected in the yield curve adn those that will surprise the market.

Nominal Default Free Bonds

Conventional government bonds of developed countries have little or no default risk. Return can be disaggregated into real return and an inflation premium. The investor must compare his own forecast for inflation with that imbedded in the yield. If the investor believes inflation will be lower than expected, the bonds are a good buy.

Defaultable Debt

Default risk in commercial bonds is reflected in a premium yield relative to Treasuries. This spread tends to widen in recessions as economic stresses increase the likelihood of default. Understanding when a bond is pricing in greater default risk than is necessary can help determine whether securities are attractively priced.

Emerging Market Bonds

The sovereign debt of non-developed countries is often priced in foreign currencies. Since the issuer cannot print the money needed to cover repayment such bonds are subject to default risk, similar to corporate debt of similar ratings. A country risk analysis often involves an understanding of local politics.

Inflation Indexed Bonds

Inflation indexed bonds allow investors to directly observe the consensus inflation forecast by comparison with the yield of conventional bonds. The yield curve will still vary with the real economy and according to supply and demand. However, higher volatility of inflation will increase their hedging value and can result in lower real yields.

Common Stock

The economy affects earnings (cash flows) and interest rates in opposite directions. Trend growth depends on labor growth, investment and productivity while the business cycle affects profitability. In emerging economies, ex-post risk premia have been higher and more volatile than in developed countries.

Real Estate

Returns are affected by growth in consumption, real interest rates, the term structure of interest rates and unexpected inflation. Economic cycles can also affect the cost of building materials and construction labor, but the net effect of lower interest rates is positive for real estate valuations.

Currencies

Exchange rates reflect the balance between supply and demand. Imports increase currency supply, usually reducing its value. Capital flows for investment purposes, however, may outweigh the effect of trade imbalances. Differences between local interest rates can also affect exchange rates, as the higher yielding currencies attract capital and thus the currency value.

Over time, small capitalization stocks have been shown to outperform large-capitalization stocks. However, timing changes in the relative performance between the two groups could lead to still-better performance. In the Fall 2007 Journal of Portfolio Management, L’Her, Mouakhar and Roberge test three nonparametric techniques derived from artificial intelligence and using 20 macroeconomic and financial variables as inputs.

The three approaches are recursive partitioning, a neural network and a genetic algorithm.

Each of the three techniques outperforms a naive small-minus-big strategy, but the best results are derived from taking the consensus of the three techniques.

In the November/December 2007 Review of the Federal Reserve Bank of St. Louis, Guidolin and Jeunesse examine the decline in the U.S. personal saving rate. Their purpose is to determine whether the decline results from methodological flaws in the measurement methods and whether it is a concern.

There are two primary measures of the U.S. personal savings rate: the NIPA measure used by the Bureau of Economic Analysis and the Flow of Funds measure used by the Federal Reserve. The NIPA measure is most commonly referenced, but is known to have several flaws, including:

• Capital gains are excluded from disposable income, understating the savings rate
• Pension benefits are excluded, but pension contributions are included
• Household interest payments are expressed in nominal rather than real terms
• Education outlays are treated as personal expenses rather than investme

Despite these issues, it becomes clear that the savings rate has declined sharply. The authors then consider three arguments that imply that the decline is not cause for concern:

1. Net wealth data rather than NIPA data should be used, capturing capital gains
2. The savings rate of the nonfinancial business sector should be taken into account
3. The Flow of Funds measure, though superior, also may understate savings rates by failing to account for productivity enhancements

Such theories and others do explain part of the decline, but none account fully for the drop. The authors conclude that neither methodological flaws nor economic theories account for the drop in savings, and that the decline remains cause for concern.

There are many factors that influence the investment performance of securities and industries. Only some of these are related to the general economy. Structural changes in a variety of categories can affect the prospects for companies and industries.

Demographics

Changes in birth rates can have a profound impact on the overall economy. The “baby boom” in the US drove many trends as the needs of a large segment of the population evolved from diapers to education, from first homes to child-raising and finally to retirement. As the group retires, it may result in wage increases as the workers must be replaced from a smaller pool or in greater demand for financial services advice.

Lifestyle

Are people living in cities or moving to suburbs? Is the divorce rate rising or falling? Are more people buying second homes or discretionary items? All of these can influence industry prospects.

Technology

Technology can make some products obsolete, and introduce entirely new products. It can also effect the efficiency of the overall economy.

Politics and Regulation

Regulations affect many industries, and the political climate, lifestyles and social values can impact the future of those regulations. New regulations, changes to existing regulations, and deregulation can all have profound impacts on company and industry prospects.

Economic indicators can be leading, lagging or coincident with changes in economic growth. Diffusion indexes can combine multiple indicators.

Advantages to leading indicator approaches to economic forecasting include:

• Intuitive, simple-to-construct models
• Availability from third parties
• Can be tailored to fit individual needs
• Effective use is well documented in economic literature

Disadvantages include:

• They have not historically worked consistently because the relationships between inputs are not static
• They can provide false signals

Deep out-of-money options tend to trade with higher implied volatility than near-money options, a phenomenon known as the volatility skew. In the October 2007 Journal of Futures Markets, Doran, Peterson and Tarrant extend this observation to ask whether the implied volatility skew becomes more positive immediately prior to a market spike or more negative immediately prior to a market crash.

They find that at the short end of the term structure, the skew does give information regarding an impending crash. There is less information conveyed from positive skew. Further along the term structure, information content from volatility skew is weak.

Econometric modeling applies quantitative methods and analysis grounded in economic theory to analysis of economic data. It can combine historical data with estimated variables to forecast GDP, and is useful for simulating the impact of changes in variables.

Advantages of economic modeling include:

• Robust multi-factor models that can closely approximate reality
• Once built, they allow new data to be quickly and consistently collected and used
• They quantify the effect of changes in exogenous variables

Disadvantages include:

• They are complex and can be time consuming to formulate
• Data inputs and relationships are difficult to forecast and are not static
• Their output requires careful analysis
• They rarely do a good job of forecasting recessions

Research has shown a negative correlation between interest rates and credit spreads that some find counterintuitive. In the Summer 2007 Journal of Fixed Income, Lin and Curtillet find that different risk components may have different relationships with the interest rate.

Lin and Curtillet find that whether spreads widen in response to an increase in the Fed target rate depends on the lagged response of the yield curve.

On a longer term basis, credit spreads are not determined by interest rates. Instead, they tend to widen in response to crises, significant financial events, and recessions.

Emerging economies can be seen as catching up to developed countries economically. They tend to need higher investment rates in physical and human capital. If domestic savings are insufficient to cover this investment, foreign capital may be needed.

Emerging economies have more volatile political and social environments, and may require structural reform to unlock their potential. They tend to be commodity-driven, or dependent upon a narrow industrial niche.

To assess country risk, investors need to ask:

1. How sound are fiscal and monetary policies?
2. What are the economic growth prospects?
3. Is the currency competitive, and are external accounts under control?
4. Is external debt under control?
5. Is liquidity plentiful?
6. Is the political situation supportive of the required policies?