FINS5568 Capstone – Portfolio Management Process
Lecture 4: Economic, Industry and Factor Analysis
Lecture Outline:
Introduction of economic and industry analysis
Business and inventory cycle
Economic growth trend
Industry analysis
Factor investment
Factor construction
Reading:
Maginn, et Al. chapter 4, Reily et al. 2012, chapter 9
Introduction
The goal of economic and industry analysis
Economic analysis help analysts understand the historical relationship between economic
variables and capital market returns
Concerning the direction, strength and lead-lag relationship
Give an analyst many advantages, for example they can better discern or forecast the inflection point
that presents unique opportunities
Industry analysis
Different industries have different return and risk drivers
Firms within an industry tend to be affected by similar forces
Classifying companies using industry provide better discipline and tend to be a good starting point
Most research house assign analysts to cover specific industries
Economic Analysis
Economic
analysis
introduction Economic output tends to have both cyclical and trend
growth component
Trend growth component determines the long-term
return expectation for asset classes, such as equity
Cyclical components affect the short-term corporate
profits and interest rate, which affect stock and bond
return
Within cyclical analysis
Inventory cycle: short-term, 2 - 4 years
Business cycle: long-term, 9 - 11 years
Economic analysis – Cyclical analysis
Measure of economic activities and output:
Gross domestic product (GDP)
Total value of final goods and services produced within a country’s borders in a specific period
Under the expenditure approach: sum of the final uses of goods and services, including consumption,
investment, changes in inventories, government spending and exports minus imports
Economists focus on real GDP, adjusting for the effects of inflation
Economic analysis – Cyclical analysis
Output gap:
The difference between the actual value of GDP and the potential output
Potential output: GDP estimated as if the economy were on its trend growth path
Affect the future inflationary pressure
Negative gap: during recession or slow growth - downward inflation pressure (suppliers reduce prices to
sell inventory as the demand is not strong)
Positive gap: during good economic conditions – spurs inflation (higher demand and price of labor and
goods increase)
Recession:
Broad-based economic downturn
Two successive quarterly declines in GDP (negative growth)
Economic analysis – Cyclical analysis
Inventory cycle
Often measured by inventory to sales ratio
Increase when business have confidence in the future economy and increase inventory to satisfy
future demand – employment also tends to increase – economy tends to grow
At certain point, the measure peaks before subsequent economy slowdown – businesses sell
down inventory and cut production
When the measure bottoms, the economy tends to be strong in the next few quarters
Long-term trend going down due to more effective inventory management techniques, such as
just-in-time inventory management
Order laptops online and will deliver to you within 2 weeks
Economic analysis – Business cycle
Business cycle
Reflects the fluctuation of GDP in relation to long-term trend growth
Business cycle and asset return relationship is well-documented
Five phases: initial recovery, early upswing, late upswing, slowdown and recession
Each cycle is different because of specific events and trends – the phases are different in terms
of duration and severity
Economic analysis – Cyclical analysis
Initial recovery
Duration of a few months
Business confidence is rising
Government stimulation by lower interest rate and/or budget deficit
Large (negative) output gap and falling inflation
Asset class returns:
Bond yield at the bottom (price is high)
Rising stock prices
Cyclical, riskier assets (small-cap stocks and high yield corporate bonds) do well
Economic analysis – Cyclical analysis
Early upswing/expansion
Duration of a year to several years
Increasing growth with low inflation
Increase confidence and inventories by companies
Rising short-term interest rates – central banks withdrawing monetary policy support
(Negative) output gap is narrowing
Asset class returns:
Flat or rising bond yield
Rising stock prices
Economic analysis – Cyclical analysis
Late upswing/expansion
Confidence and employment are high
Output gap closed, inflation increases and the economy is at risk of over-heating
Central banks tend to further tighten monetary policy and rising short-term interest rates
Asset class returns:
Rising bond yield
Rising/peaking stock prices with increased risk and volatility
Economic analysis – Cyclical analysis
Slowdown
Could last from few months to a year or longer
Business confidence falling and reducing inventory
Inflation is still rising due to positive output gap
Short-term interest rates are at peak
Asset class returns:
Bond yield have peaked and start to fall with rising prices
Falling stock prices
Inverted yield curve (short-term yields are higher than the long-term ones)
Economic analysis – Cyclical analysis
Recession
Six months to a year
Decline in inventory, confidence and profits
Increase in unemployment and business bankruptcies
Inflation tops and start to fall
Asset class returns:
Falling short-term interest rates – central banks monetary support
Falling bond yield (rising prices) – investor fly to safety
Stock prices tend to go down until near the end of the recession
Economic
analysis –
inflation
Inflation
Inflation means rising prices (decreasing purchasing
power of currency unit) and deflation means falling
prices
Commonly measured by consumer price indices (CPI):
price of a basket of goods and services
Central banks try to keep inflation low without
succumbing to deflation
High inflation is harmful to the economy
Uncertainty about purchasing power of money -
discourages investment and savings
Very high inflation can lead to social unrest and revolt –
basic goods and services not affordable
Redistribution purchasing power from those with fixed
nominal income (such as pensioners) to those with
variable income (workers whose salary increases with
inflation)
High inflation has been defeated mostly by the end of the
twentieth century
Economic
analysis –
inflation
Inflation tends to accelerate in later stages of business
cycle when the output gap has been closed
Inflation falls during a recession or early years
afterward – large output gap
Deflation can be a threat to the economy because:
Undermines debt-financed asset (such as home
property) and encourages default
Imagine you purchased a house with $1 million with a
$900,000 mortgage but find next year the property is
only worth $800,000.
Reduces central banks ability to stimulate the
economy through reducing interest rate as nominal
interest rate can be very low or close to zero due to
deflation.
Leaving less room for central banks to further reduce
nominal interest rate
Economic analysis – inflation and asset class
returns
Inflation above expectation – inflation shocks:
Cash (positive): rising rates to compensate the higher inflation
Bonds (negative): higher yield due to higher inflation premium
Equity (negative): generally perform better than bonds as companies can potentially pass
on the inflated costs to customers but rising inflation could lead to recession and central
bank tightens policies, which is negative for equities
Real estate and other real assets (positive): asset value (price) and cash flow tend to
increase
Economic analysis – factors affect business
cycle
Consumer and business spending:
Consumer spending amounts 60-70% of GDP for most developed economies and therefore
most important business cycle factor
Data: retail sales and store sales data, tend to have seasonal patterns
The most important factor affecting spending is income after tax
Business spending
Smaller share in GDP compared to consumer spending
But more volatile – business investment can fall by 10-20% or more during recession
Economic analysis – factors affect business
cycle
Monetary policy:
Central banks use monetary policy to adjust the performance of the economy
The goal is to keep growth near long-run sustainable rate
Expansionary monetary policy:
Increase money supply and/or decrease interest rate – encourage business and individual borrowing
and spending, also can lower exchange rate and stimulate exports
Applied during recovery and early upswing phase of the business cycle
Contractionary monetary policy:
Decrease money supply and/or increase interest rate
Applied during late upswing
Economic analysis – factors affect business cycle
Monetary policy – predicting central bank behaviour with the Taylor rule
= + + 0.5 ? + 0.5( ? )
central bank targe nominal short-term rate
short-term interest rate that would be achieved if GDP growths were on trend and
inflation on target
Example 1: What is the short-term interest target if the neutral rate is 2%, inflation target is 2%,
expected inflation is 4%, GDP long-term trend is 2.5% and the forecasted GDP growth is 3%
Solution: 2 + 4 + 0.5(4-2) + 0.5(3-2.5) = 7.25%
Economic analysis – factors affect business
cycle
Fiscal policy:
Government can intervene in the economy through fiscal policy: spending and tax rates
Expansionary fiscal policy:
Decrease tax – leave more money to individual and business for spending
Increase government spending – directly increase the demand for goods and services
Contractionary fiscal policy:
Increase tax and/or decrease government spending
Spending greater than income will lead to government budget deficit
Importantly, it is the change in government spending matters
Changes in government deficit that occurs naturally during business cycle are not stimulative or
restrictive
Economic analysis – factors affect business
cycle
Yield curve:
Relationship between interest rates and maturity of debt securities
Typically upward shape - longer maturity security need to offer higher return for investors –
loss of liquidity, greater interest rate risk
Inverted yield curves have been strong indicators of economic recession
In anticipation of economic downturn, investors buy into long-term safe assets
Drive up the price and long-term asset – lower yield
Economic analysis – factors affect business
cycle
Yield curve:
Economic analysis – factors affect business
cycle
Yield curve:
Sensitive to government policy and economic conditions
Expansionary/stimulative fiscal and monetary policy: upward sloping and economy likely to expand
Contractionary/Restrictive fiscal and monetary policy: downward sloping and economy likely to
contract
Conflicting policy: flat or moderately steep (if monetary policy is stimulative) and the impact on
economy is less clear
Within business cycle:
Steep at the bottom of the cycle, flatten during expansion, flat or inverted at the top of the cycle
Economic analysis – economic growth trend
Economic growth trend:
The long-term growth path of the economy – average growth rate around which the economy
cycles
Economic trends exist independently of the cycle but are related to it
It is key input in the discount cash flow models of expected return
The simplest way to estimate the growth rate is to split aggregate growth trend into:
Growth from changes in employment – labour inputs
Growth in potential labour force size
Growth in actual labour participation
Growth from labour productivity
Growth from capital inputs
Total factor productivity (TFP) growth
Economic analysis – economic growth trend
Example 2: Given the following information, what is the forecast economic growth trend?
Growth in labor force participation: 1.5%
Growth in labor force size: 2%
Growth in capital input: 1%
Growth in TFP: 0.5%
Solution: 1.5% + 2% + 1% +0.5% = 5%
Economic analysis – economic growth trend
Government structural policies: policies that affect the limits of economic growth and
incentives within private sectors:
Pro-growth structural policies:
1. Sound fiscal policy: limited budget deficit and reduce the burden of interest
2. Minimal government intrusion on the private sector and encourage competition in the private
sector - free market tends to more efficient in resource allocation
3. Develop infrastructure and human capital through education and training
4. Sound tax policies
Industry Analysis
Industry analysis
Different industries perform differently during different stages of business cycle
Industry/sector analysis facilitates sector rotation strategy – better predict industry performance
Improve within industry security selection – identify drivers of industry performance and select
securities that benefit the most
Typical patterns of industry performance during business cycle
Financial stocks often recover first towards the end of a recession
Consumer durable goods do well as the economy recovers
Cyclical companies tend to move in anticipation of business cycle
Consumer staples tend to outperform during downturn
Industry analysis
Can examine the variables that drive performance:
High inflation often benefits basic material stocks
High interest rates hurt housing and construction
Weak domestic currency helps exporters
Low growth rates tend to help few companies that can deliver high growth
High energy costs hurt transportation companies, such as airlines
Note that sector rotation strategy might be difficult as each business cycle is different
Industry analysis
Structural Economic changes impact the industry:
Demographics: aging population, shrinking middle-class, and racial and ethnical diversity
Lifestyle: reading habit of different generations, divorce and single parent family
Technology: Amazon’s impact on retail, Uber on local transportation, Airbnb on hotel
Politics and regulation
Factor Analysis
Factor analysis - Introduction
Factors are broad and persistent drivers of return and risks of securities:
Arbitrage pricing model (APT) – Stephen Ross, 1976
There exist multiple factors as compared to the single market factor in CAPM
Equities:
Small size (small firm outperform big firm)
Value (value stocks output growth stocks)
Momentum (past winner tend to outperform losers)
Factor analysis - Introduction
Factors can be captured in systematic and cost-effective ways
Earlier years, factor investment is mostly used by hedge funds
Nowadays, there are numerous smart beta investment funds/ETF:
Target single or multiple factors
Generate extra return but low cost and transparency of index investment
Factor performance can be cyclical:
Momentum: outperform in expansion
Quality: outperform in economic slowdown and recession
Factor analysis – Smart Beta