Archive for the 'Economic Analysis' Category

Factors Affecting the Business Cycle

The business cycle refers to the swings in gross domestic product from recovery to recession. There are several factors influencing the business cycle.

Consumers tend to be the most important, reflecting 60-70% of GDP in developed countries. Trends in consumer spending can be monitored through retail sales and personal income data.

Business spending on inventories and investment is a smaller but more volatile component of GDP. It can be tracked using surveys such as PMI or ISM.

Monetary policy is used by governments to dampen the overall business cycle. The ability to use monetary policy as a business cycle lever is dampened by inflation, the pace of growth, unemployment levels and capacity utilization.

Posted on 18th February 2009
Under: Economic Analysis, FInancial Planning, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Endogenous Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Endogenous growth theory assumes that marginal productivity of capital does not necessarily decline as capital is added. Instead, technological advances and improved labor force education can increase productivity and lead to efficiency gains. As such, the economy may never reach a steady state.

Posted on 25th October 2008
Under: Economic Analysis, Fixed income investments | No Comments »

Endogenous Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Endogenous growth theory assumes that marginal productivity of capital does not necessarily decline as capital is added. Instead, technological advances and improved labor force education can increase productivity and lead to efficiency gains. As such, the economy may never reach a steady state.

Posted on 25th October 2008
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Neoclassical Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Neoclassical growth theory assumes that the marginal rate of productivity of capital declines as more capital is added. It predicts that the long-term level of GDP depends on the country’s savings rate, but that the long-term growth rate in GDP does not. This is because as the level of GDP increases, additions to capital provide a diminishing impact and the economy reaches a steady state.

Countries operating below their steady state should experience accelerating growth, while those operating above it will see the growth rate slow.

Posted on 25th September 2008
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Global Industry Analysis

Companies that operate in global industries are subject to influences from both their country of domicile and their industry. As a result, both country analysis and global industry analysis are typically needed.

Country analysis can include not just the country of domicile, but also the major end markets in which a company operates. In each significant country market, analysts and economists typically monitor a wide range of economic, social and political variables. These can include:

  • Expected real and nominal growth
  • Monetary and fiscal policy
  • Investment climate
  • Business cycle stage
  • Long-term sustainable growth
  • Competitiveness
  • Factors affecting employment and wages
  • Social and political environment

Business cycles across countries are not fully synchronized, so some countries may recover or enter recession sooner than others. However, as markets become more globally integrated international business cycles tend to converge.

To estimate long-term sustainable growth, there are two primary competing theories.

  • Neoclassical growth theory assumes that the marginal productivity of capital declines as more capital is added.
  • Endogenous growth theory assumes that technological advances and improved labor force education can result in efficiency gains. These can prevent the decline in marginal productivity of capital.

As industries become more global, the country factors are also becoming less significant. Industry factors to consider include:

  • Demand analysis – how is the global market for the company’s products and services growing?
  • Value creation – Where on the supply chain is value created? Are there advantages to size, scale or scope? Is there a productivity learning curve in the industry?
  • Industry life cycle – is the industry a pioneer, accelerating growth, mature, stable or decelerating industry?
  • What is the industry’s competitive structure?
  • What is the competitive advantage pursued by each industry participant?

Posted on 25th August 2008
Under: Economic Analysis, Fundamental Analysis, Industry Analysis | No Comments »

Portfolio Monitoring: Security Characteristics

Portfolio monitoring includes monitoring changes in the characteristics of individual securities or asset classes. Over time, underlying average returns, volatility and correlations with other asset classes can change. Such changes alter the appropriate mix of assets for meeting an investor’s objectives and constraints. If the changes are perceived as temporary, they may also present opportunities to make tactical changes.

The market and economic environment also require monitoring. Of particular importance can be the yield curve, market risk premia, central bank policy, and unusual deviations from normal relationships between securities or asset classes.

Posted on 4th August 2008
Under: Active Management, Asset Allocation, Economic Analysis, FInancial Planning, Portfolio Management | No Comments »

Six Stages of Business Cycle Investing

In Technical Analysis Explained, Martin Pring notes that since there are three major financial markets (stocks, bonds and commodities) and each has two turning points in a given cycle, there are six turning points in each cycle. He calls these turning points the six stages and uses them as a reference point for identifying the current phase of the business cycle and by extension the next likely turning point.

Stage 1: Slowing growth rates or early recession. Interest rates start to fall and bonds rally.

Stage 2: Business cycle trough. Stocks begin to rally.

Stage 3: Late recession and early recovery. Commodities begin to rally.

Stage 4: Early recovery. Interest rates trough and bonds peak.

Stage 5: Cycle peak. Stocks peak.

Stage 6: Slowing growth, commodities peak.

Posted on 25th July 2008
Under: Economic Analysis, Investing in Commodities, Investing in Stocks, Investing in bonds, Technical Analysis | No Comments »

Approaches to Forecasting Exchange Rates

Purchasing Power Parity

Purchasing power parity (PPP) is based on the belief that movements in exchange rates should offset any difference in inflation between two economies. Over longer time horizons, purchasing power parity does tend to hold, in part because governments take the concept seriously and act to control relative inflation rates. In the short term, however, other factors such as capital flows can overwhelm the impact of PPP.

Relative Economic Strength

This concept focuses on investment flows rather than trade flows. It suggests that strong economies attract capital, which causes the currency to appreciate. Foreign investors must always weigh whether the higher yield offsets the risk of inflated currency values. Relative Economic Strength indicates how currencies should respond to economic news, but does not imply a “true” currency value. Because of this, many investors use it in conjunction with PPP to form a complete theory of interest rate movements.

Capital Flows

Focuses on expected capital flows, particularly with respect to long-term capital investments. Capital flows can reverse the normal relationship between currencies and short-term interest rates, as the stimulative effect of a lower interest rate may outweigh the lower yield.

Savings-Investment Imbalances

This theory explains currency movements in terms of savings relative to capital investment. If domestic savings are insufficient to cover capital investments, the remainder must come from foreign sources. To the extent that foreign investment is not offset by a trade imbalance, the currency must rise.

Posted on 19th July 2008
Under: Asset Allocation, Economic Analysis, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Market Movements and the Business Cycle

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.

Posted on 25th June 2008
Under: Economic Analysis, Technical Analysis | No Comments »

Using Economic Information to Forecast Asset Class Returns

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.

Posted on 19th June 2008
Under: Asset Allocation, Economic Analysis, FInancial Planning, Institutional Investing, International Investing, Investment Returns, Portfolio Management | No Comments »