Reading 14 Capital Market Expectations

FinQuiz Notes 2 0 1 8
1. INTRODUCTION

Capital market expectations (CME) (also known as By contrast, micro expectations represent the investors’
macro expectations) represent the investors’ expectations regarding the risk and return prospects of
expectations regarding the risk and return prospects of individual assets. They facilitate investors in security
broad asset classes. They help investors in formulating selection and valuation.
their strategic asset allocation, that is, in setting rational
return expectations on a long term basis for globally
diversified portfolios.

2. ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES

A Framework for Developing Capital Market some subset e.g. a single international area); or
2.1
Expectations • Broad asset class (e.g. equity, fixed-income, or real
estate); or
A framework for developing Capital market • Economic sector/industry/sub-industry basis;
expectations has the following seven steps.
The historical data can be used as a baseline and may
1. Specify the final set of expectations that are needed,
be adjusted for analyst’s views e.g. if an analyst is
including the investment time horizon: This step
optimistic (pessimistic) relative to the consensus on the
involves clearly specifying the questions that need to
prospects for asset class A, then he/she may make an
be answered.
upward (downward) adjustment to the historical mean
return.
• An investor/analyst must determine the specific
objectives of the analysis. E.g. for a taxable investor, 3. Specify the method(s) and/or model(s) that will be
the objective is to develop long-term after-tax used to formulate CME and the information required
capital market expectations. to develop such models:
• An investor/analyst must specify the relevant set of
asset classes (consistent with the investment
• The analyst should clearly specify the method(s)
constraints) on which the investor/analyst needs to
and/or model(s) that will be used to develop CME.
develop capital market expectations.
• The method(s) and/or model(s) used must be
• It is important to understand that the scope of the
consistent with the objectives of the analysis and
capital market expectations-setting framework is
investment time horizon e.g. a DCF method is most
directly related with the number and variety of
appropriate to use for developing long-term equity
permissible asset class alternatives i.e. the greater
market forecasts.
the number and variety of permissible asset classes,
the wider the scope of setting capital market
expectations. Refer to Example 1 on page 9. 4. Determine the best sources for the information
needed: The analysts/investors should search for the
best and most relevant sources for the information
NOTE:
needed and should be constantly aware of new,
If the number of asset classes is n, the analyst will need to superior sources for their data needs. It involves
estimate: considering following factors:

• n number of expected returns; • Data collection principles and definitions;

• n number of standard deviations; • Error rates in collection and calculation formulas;
• (n2 – n) / 2 distinct correlations (or the same number • Quality of asset class indices (i.e. Investability,
of distinct covariances); correction for free float, turnover in index
constituents);
2. Research the historical record: Historical data provide • Biases in the data;
some useful information on the investment • Costs of data etc;
characteristics of the asset. Hence, the historical
performance of the asset classes should be analyzed In addition, the analysts must select the appropriate
in order to identify their return drivers. Analyzing each data frequency e.g. long-term data series should be
asset class’s historical performance involves gathering used for setting long-term expectations or evaluating
macroeconomic and market information in different long-term volatility. In general,
ways e.g., by:
• For setting long-term CME, quarterly or annual data
• Geographical area (e.g., domestic, nondomestic, or series are useful.

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Reading 14 Capital Market Expectations FinQuiz.com

• For setting shorter-term CME, daily data series are 2.2 Challenges in Forecasting (section 2.2.1 - 2.2.9)
useful.
The data and assumptions used in the forecasting model
5. Interpret the current investment environment: The must be error free. The challenges associated with
analyst should interpret the current investment forecasting include:
environment using the selected data and methods
and should employ consistent set of assumptions. 1) Limitations of Economic Data:
Also, he should apply experience and judgment
(where necessary to interpret any conflicting
• Definitions and calculation methods may change
information within the data) so that the conclusions
over time. This may affect the validity of time-series
are mutually consistent.
data.
• Errors in collection and measurements of data and in
6. Provide the set of expectations that are needed and
document conclusions: This step involves the calculation formulas;
documenting answers to the questions formulated in • Timeliness of data i.e. time lag with which economic
step 1. In addition to answers and conclusions, the data are collected, processed, and disseminated.
analyst should also document reasoning and For example, the International Monetary Fund
assumptions associated with the conclusion. The set of sometimes provides macroeconomic data for
expectations obtained in step 6 are then used to developing economies with a lag of two years or
develop forward-looking forecasts on capital markets. more.
o The greater the lag before information is reported
7. Monitor actual outcomes to provide feedback to (i.e. the older the data), the greater the risk that it
improve the CME development process: This step provides irrelevant and uncertain information
involves monitoring and comparing actual outcomes about the present situation.
against expected outcomes to identify weaknesses in • Changes in the construction method of data: The
the CME development process so that the bases of indices of economic and financial data are
expectations-setting process or methods can be changed on a periodic basis to reflect more current
improved. bases. This process is known as re-basing. Re-basing
simply reflects a mathematical change rather than
Beta versus Alpha Research: substantive change in the composition of an index.
Re-basing may result in risk of mixing data indexed to
Beta Research: Beta research involves developing different bases.
capital market expectations concerning the systematic
risk and returns to systematic risk. Unlike alpha research, 2) Data Measurement Errors and Biases: The errors and
beta research is centralized which implies that CME biases in data measurement include:
inputs used across all equity and fixed-income products
are consistent. Transcription errors: The errors relating to gathering
and recording of data are called transcription errors.
Alpha Research: Alpha research involves developing Transcription errors are most serious when they reflect
expectations regarding individual assets in an attempt to bias.
capture excess risk-adjusting returns by a particular
investment strategy. Survivorship bias: Survivorship bias occurs when a
data series reflects data on surviving (or successful)
Three Characteristics of Good Forecasts: Good forecasts entities and do not reflect post-delisting data (e.g.
are data on entities with poor performance which have
been removed from the database). This bias results in
1) Unbiased, objective, and well researched; overestimated historical returns.
2) Efficient i.e. has minimum forecasting errors;
3) Internally consistent i.e. if asset class A and B are Appraisal (smoothed) data: Infrequently traded and
perfectly negatively correlated and asset class B and illiquid assets (e.g. real estate, private equity etc) do
C are also perfectly negatively correlated, then asset not tend to have up-to-date market prices; rather,
class A and C must be perfectly positively correlated. their values need to be estimated, known as
appraised values. Appraised values (i.e. smoothed
data) represent less volatile values. As a result, the
Practice: Example 4 & 5, correlations of such assets with traditional assets (i.e.
Volume 3, Reading 14. equities and fixed income) and risk (S.D.) of assets are
underestimated or biased downward.

• Remedy to mitigate smoothing effect: The smoothed

data bias can be mitigated by rescaling the data so
that their dispersion (i.e. S.D.) is increased but the
mean of the data is unchanged.
Reading 14 Capital Market Expectations FinQuiz.com

3) The Limitations of Historical Estimates: The simplest a short time series may give period-specific results that
approach to forecasting is to use historical data to may not reflect a longer time period. Similarly, test based
directly forecast future outcomes. However, the on long time period may suffer from structural changes
historical estimates may not be good predictors of occurring during the time frame, resulting in two data
future results because the risk/return characteristics of sets with different relationships. As a result, forecasted
asset classes may change as a result of changes in relationship estimated from the first period may not hold
technological, political, legal and regulatory for second sub-period.
environments and disruptions i.e. war or natural
disaster. These so called regime changes introduce 6) The Failure to Account for Conditioning Information
the statistical problem of non-stationarity (where may lead to misperceptions of risk, return, and risk-
different parts of a data series exhibit different adjusted return: Future risk and return of an asset as of
underlying statistical properties). In addition, the today depend or are conditional upon on specific
disruptions in a certain time period may temporarily characteristics of the current marketplace and
increase volatilities in that period which may not be prospects looking forward. Hence, the expectations
relevant for the future period. concerning future risk and return of an asset must take
into account any new, relevant information in the
• Although use of long time series data increases the present. For example, since systematic risk of an asset
precision* of estimates of population parameters class varies with business cycle, the expectations
and reduces the sensitivity of parameter estimates to concerning systematic risk of an asset class should be
the starting and ending dates of the sample; conditioned upon the state of the economy.
however, using long time series (reflecting multiple
regimes) may increase the risk of non-stationarity in EXAMPLE
the data (due to structural changes during the time
frame) and consequently, the risk of including Suppose,
irrelevant data. • Beta of an asset class in economic expansions =
• In addition, for some time-series analysis, the data 0.80
series of the required length may not be available. • Beta of an asset class in economic recessions = 1.2
Using high-frequency data (weekly or even daily) in • Expected return on market during expansion = 12%
order to get data series of required length increases • Expected return on market during recession = 4%
risk of asynchronism (i.e. discrepancy in the dating of • Risk-free rate (both recession & expansion) = 2%
observations due to use of stale/out-of-date data)
and results in underestimated correlations estimates. Unconditional beta = 0.50 (0.80) + 0.50 (1.2) = 1.0
Unconditional risk-free rate = 0.50 (2%) + 0.50 (2%) =
*Precision of the estimate of the population mean is 2%
proportional to 1 / √number of observations Unconditional expected return on market = 0.50
(12%) + 0.5 (4%) = 8%
4) Ex Post Risk Can Be a Biased Measure of Ex Ante Risk: Unconditional expected return on asset class i
In general, the ex-ante risk and ex-ante return are (using CAPM) = 2% + 1.0 (8% - 2%) = 8%
underestimated on backward-looking basis. Hence, Expected return on market during expansion (using
ex-post risk estimates may be a poor proxy of the ex CAPM) = 2% + 0.80 (12% - 2%) = 10%
ante risk estimate. The investment decision-making Expected return on market during recession (using
must be based on ex-ante risk measures rather than CAPM) = 2% + 1.20 (4% - 2%) = 4.4%
ex-post risk measures. Conditional expected return on market = 0.50 (10%)
+ 0.50 (4.4%) = 7.2%
5) Biases in Analysts’ Methods Unconditional alpha = 7.2% - 8% = -0.8%
Alpha during expansion and recession = 0.50 (0%) +
Data-mining bias: Data mining bias refers to over-using 0.50 (0%) = 0%
or overanalyzing the same or related data (i.e. mining
the data) until some statistically significant pattern is 7) Misinterpretation of Correlations: A significantly high
found in the dataset. Two signs that may indicate the correlation between variable A and B implies one of
existence of data-mining bias include: the following things:

i. Many of the variables used in the research are not • Variable A is predicted by variable B i.e. variable B is
reported; exogenous variable (which is determined outside
ii. No plausible economic relationship exists among the system) and variable A is endogenous variable
variables; (which is determined within the system).
• Variable B is predicted by variable A i.e. variable A is
The data mining bias can be detected by using out-of- exogenous variable and variable B is endogenous
sample data to test the statistical significance of the variable.
patterns found in the dataset. • Neither variable A predicts B nor B predicts A; rather,
a third variable C predicts A and B. the variable C is
Time-period bias: Time-period bias occurs when referred to as a control variable.
outcomes/results are time-period specific. For example,
Reading 14 Capital Market Expectations FinQuiz.com

The impact of multiple control variables can be c) The confirming evidence trap: It is a tendency of
analyzed using multiple-regression analysis. people to seek and focus on information that
confirms their beliefs or hypothesis and ignore, reject
Multiple-regression analysis
A = β0 + β1 B + β2 C + ε or discount information that contradicts their beliefs.
Confirmation bias implies assigning greater weight to
• The coefficient β1 represents the partial correlation information that supports one’s beliefs. This bias can
between A and B i.e. the effect of variable B on be reduced or mitigated by:
variable A after taking into account the effect of the
control variable C on A. • Collecting and examining complete information i.e.
• The coefficient β2 represents the partial correlation both positive and negative.
between A and C i.e. the effect of variable C on • Actively looking for contradictory information and
variable A after taking into account the effect of contra-arguments.
variable B on A. • Being honest with one’s motives and investment
• When estimated value of β1 is significantly different objectives.
from 0 but β2 is not significantly different from 0, it
indicates that variable B predicts variable A. d) The overconfidence trap: It is a tendency of people to
overestimate their knowledge levels and their ability
Time series analysis
A = β0 + β1 Lagged values of A + β2 to process and access information. In this bias, people
Lagged values of B + β2 tend to believe that they have superior knowledge
Lagged values of C + ε and they make precise and accurate forecasts than
it really is.
NOTE:
It must be stressed that two variables may reflect low or • The overconfidence trap may result in using too
zero correlation despite strong but non-linear relationship narrow range of possibilities or scenarios in
because correlation measure ignores non-linear forecasting.
relationships. • The overconfidence trap can be avoided by
widening the range of possibilities around the
8) Psychological Traps primary target forecast.

Psychological traps can undermine the analyst’s ability

e) The prudence trap: It is the tendency of analysts to be
to make accurate and unbiased forecasts.
extremely cautious in forecasting in an attempt to
avoid making any extreme forecasts which may
a) The anchoring trap: It is a tendency of people to
adversely impact their career. As a result, they make
develop estimates for different categories based on a
forecast estimates that are in line with other analysts
particular and often irrelevant value (both
(representing herding behavior).
quantitative & qualitative), called anchor (i.e. a
target price, the purchase price of a stock, prior
beliefs on economic states of countries or on • The prudence trap can be avoided by widening the
companies etc) and then adjusting their final range of possibilities around the target forecast.
decisions up or down based on that “anchor” value.
f) The recallability trap: It is the tendency of analysts to
• Anchoring bias implies investor under-reaction to assign higher weight to more easily available and
new information and assigning greater weight to the easily recalled information e.g. information related to
anchor. catastrophic or dramatic past events. This bias can be
• Anchoring bias can be mitigated by avoiding avoided by using objective data and procedures in
premature conclusions. decision-making.

b) The status quo trap: It is a tendency of people to

prefer to “do nothing” (i.e. maintain the “status quo”) Practice: Example 11,
instead of making a change. In the status-quo bias, Volume 3, Reading 14.
investors prefer to hold the existing investments in their
portfolios even if currently they are not consistent with
their risk/return objectives.
9) Model Uncertainty: Investment analysis may be
subject to two kinds of uncertainty i.e.
• It is closely related with avoiding “Error of
commission” (i.e. regret from an action taken) and
i. Model uncertainty is the uncertainty related to the
“Error of omission” (i.e. regret from not taking an
accuracy of the model selected. The model
action).
uncertainty can be evaluated by analyzing the
• The status-quo trap can be overcome by following a
variation in outcomes of the models from shifting
rational analysis in investment decision-making.
between the several most promising models.
Reading 14 Capital Market Expectations FinQuiz.com

ii. Input uncertainty is the uncertainty related to the Capital market anomalies (inefficiencies) often exist due
accuracy of inputs used in the model. to input and model uncertainty.

3. TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS

Shrinkage Estimator = (Weight of historical estimate ×

3.1 Formal Tools (Section 3.1.1 – 3.1.4)
Historical parameter estimate) +
(Weight of Target parameter
Formal tools used for formulating capital market estimate × Target parameter
expectations include: estimate)
For example,
I. Statistical methods
II. Discounted cash flow models Shrinkage estimator of the covariance matrix = (Weight
III. The risk premium approach of historical covariance × Historical covariance) +
IV. Financial market equilibrium models (Weight of Target covariance × Target covariance)

1. Statistical Methods: There are two major types of Where,

Statistical methods. Target parameter estimate = Alternative parameter
estimate
• Descriptive Statistics: Statistical Methods that are
used to organize and summarize data so that • The target covariance matrix can be a factor-
important aspects of a dataset can be described model-based estimate or can be a covariance
are known as descriptive statistics. estimate based on the assumption that each pair-
• Inferential Statistics: Statistical Methods that are used wise covariance is equal to the overall average
to make estimates or forecasts about a larger group covariance.
(population) based upon information taken from a
smaller group (sample) are known as inferential
statistics. • Weights reflect the analyst’s relative belief in the
estimates e.g. the more strongly an analyst believes
in the historical estimate, the larger the weight of the
a) Historical Statistical Approach: Sample Estimators: In a historical estimate.
historical statistical approach, historical data is used • The historical sample covariance matrix is not
as the basis for forecasts. appropriate to use for small samples. Hence,
shrinkage estimation is a superior approach for
• A sample estimator is a formula used to compute an estimating population parameter for the medium
estimate of a population parameter. The value of and smaller size because it helps to decrease (i.e.
that estimate (statistic) is called a point estimate. shrink) the impact of extreme values in historical
• The point estimate is useful to estimate population estimates and increases the efficiency of the
parameter when the time series data is stationary. parameter estimates. The more plausible target
• In a mean-variance framework, the analyst might estimate is selected, the greater the improvement in
use: the accuracy of the estimate.
o The sample arithmetic mean of total return or • The Shrinkage estimation method is commonly used
sample geometric mean of total return as an for computing covariances and mean returns.
estimate of the expected return. The arithmetic
mean is appropriate to use to estimate the mean Example:
return in a single period whereas the geometric
mean is appropriate to use to estimate mean Suppose
return for multi-periods. For a risky (volatile)
variable, the geometric mean return will always be • Using factor model, the estimated covariance
< the arithmetic mean return. between domestic shares and bonds = 40
o The sample variance as an estimate of the • Using historical estimate, the estimated covariance
variance; and between domestic shares and bonds = 75
o Sample correlation as an estimate of correlation. • Weight of historical estimate = 0.30
• Weight of target estimate = 0.70
b) Shrinkage Estimators: Shrinkage estimation is a
process in which an estimate of a parameter is Shrinkage estimate of the covariance = 0.70 (40) + 0.30
computed by taking weighted average of a historical (75) = 50.5
estimate of a parameter and some other estimate of
a parameter. Shrinkage estimation is also known as
the “two-estimates-are-better-than-one” approach.
Reading 14 Capital Market Expectations FinQuiz.com

Uses of Multifactor models for estimating covariances:

Practice: Example 12,
Volume 3, Reading 14. 1) A multifactor model simplifies the method of
estimating covariances because the estimates of
covariances between asset returns can be computed
from the assets’ factor sensitivities.
c) Time-Series Estimators: Time series estimation involves 2) A multifactor model helps to filter out noise (i.e.
regressing the value of dependent variable on the random fluctuations in the data specific to the
lagged values of dependent variable and lagged sample period) provided that appropriate risk factors
values of other selected variables. Time series are selected
estimation methods are useful to make short-term/ 3) A multifactor model simplifies verification of the
near-term forecasts for financial and economic consistency of the covariance matrix because when
variables. They are also used to forecast near-term the smaller factor covariance matrix is consistent then
volatility, assuming variance clustering exists. any covariances estimated using smaller factor
covariance matrix is also consistent.
• Variance clustering: When large (small) fluctuations
in prices are followed by large (small) fluctuations in Example:
prices in random direction, it is referred to as
Suppose that returns of all assets in the investable
“Variance Clustering”.
universe depend on two factors*:
σ2t = βσ2t-1 + (1 – β) ε2t
Where,
1. Global equity factor
σ2t = Volatility in period t
σ2t-1 = Volatility in previous period
ε2t = a random “noise” term • Standard deviation of global equity = 12%

β = Weight on σ2t-1
Measure of rate of decay of Variance for global equity = (0.12)2 = 0.0144.
the influence of the value of volatility in period
t-1 on value of volatility in period t
with 0 2. Global bond factor
<β< 1.
o The higher (lower) the β, the greater (smaller) the • Standard deviation of global bonds = 5%

influence of the value of volatility in period t-1 on Variance for global bonds = (0.05)2 = 0.0025
value of volatility in period t. • Correlation between global equity and global
bonds = 0.30
d) Multifactor Models: A multifactor model involves
regressing the value of dependent variable on values Covariance between global equity and global bonds =
of a set of return drivers or risk factors. It can be stated S.D. of Global equity × S.D. of Global bonds × Correlation
as: between Global equity & Global bonds =

Ri = ai + bi1F1 + bi2F2 + … + biK FK + εi 12% × 5% × 0.30 = 0.0018

where, Equity-bond covariance matrix

Ri = Return to asset i Global Equity Global Bonds
ai = Intercept term in the equation for asset i Global Equity 0.0144 0.0018
Fk = Return to factor k, k = 1, 2, …, K Global Bonds 0.0018 0.0025
bik = Sensitivity of the return to asset i to the return to
factor k, k = 1,2, …, K NOTE:

• Markets’ factor sensitivities (bik), also known as factor A covariance matrix is a table that shows the
betas or factor loadings, measure the responsiveness covariances for the return drivers or risk factors.
of markets to factor movements.
Suppose the sensitivities of two markets A and B to
global equity and global bonds are as follows.
εi = An error term that represents the asset’s
idiosyncratic or residual risk i.e. portion of the return Sensitivities
to asset i not explained by the factor model.
Global Global Residual Risk
Equity Bonds (%)
• It is assumed that an error has mean value of zero Market A 1.11 0 10.0
and is uncorrelated with each of the K factors and Market B 1.07 0 8.0
with the error terms in the equations for other assets.
• The zero sensitivity of Market A to global bonds does
not imply that Market A has zero correlation with
global bonds; rather, it implies that the partial
correlation (i.e. correlation after removing impact of
the other markets) of Market A with global bonds is
Reading 14 Capital Market Expectations FinQuiz.com

zero. Hence, return in Market A is not derived by • The growth rate (g) can be estimated as the growth
global bonds. rate in nominal GDP.

Variance of market i can be computed using following Nominal GDP = Real growth rate in GDP + Expected
formula: long-run inflation rate

Mii = b2i1 Var (F1) + b2i2 Var (F2) + 2bi1bi2 Cov (F1, F2) + Earnings growth rate = Nominal GDP growth rate +
Var(εi) Excess Corporate growth (for the
For i = 1 to n index companies*)

Covariance of market i with market j can be computed *Excess corporate growth reflects adjustment for any
using following formula: differences between economy’s growth rate and that of
equity index. E.g. for a broad-based equity index, the
Mij = bi1 bj1 Var (F1) + bi2 bj2Var (F2) + (bi1 bj2 + bi2 bj1) excess corporate growth adjustment, if any, should be
Cov (F1, F2) small.
For i = 1 to n, j = 1 to n, and i ≠ j Grinold-Kroner Model: It is a restatement of the Gordon
growth model and it explicitly takes into account the
Computing Covariance between Markets A and B: with i impact of number of shares in the market (as
= 1 for Market A and j = 2 for Market B: represented by stock repurchases)and changes in
market valuations as represented by the price to
M12 = (1.11) (1.07) (0.0144) + (0) (0) (0.0025) + [(1.11) (0) + earnings (P/E) ratio. It is expressed as follows:
(0) (1.07)] (0.0018) = 0.01710288
ࡰ
E (Re) ≈ - ∆S + i + g + ∆PE
ࡼ
*A multi-factor approach can also be used depending
on investors/analysts needs. Where,
2. Discounted Cash Flow Models: In Discounted cash E (Re) = Expected rate of return on equity
flow models (DCF models), an asset’s intrinsic value is D/P = Expected dividend yield
computed as the present value of its (expected) cash ∆S = Expected % change in number of shares
flows. It is a forward-looking model and is most outstanding  this term is negative (i.e. -∆S)
appropriate to use for making long-term forecasts. when there are net positive share repurchases;
∆S is positive when number of shares outstanding
It is expressed as: increases.

∞ -∆S = Positive repurchase yield

CFt
V0 = ∑ (1 + r )
t =1
t
+∆S = Negative repurchase yield

Where, i = Expected inflation rate

V0 = Value of the asset at time t = 0 (today) g = Expected real total earnings growth rate
CFt = Cash flow (or the expected cash flow, for risky (generally, it is not identical to EPS growth rate,
cash flows) at time t with changes in shares outstanding)*
r = Discount rate or required rate of return. Assuming ∆PE = Per period % change in the P/E multiple
flat term structure, the discount rate will be the
same for all time periods. *GDP Growth rate = Labor productivity growth + Labor
supply growth
3.1.2.1 Equity Markets
Where, labor supply growth = Population growth rate +
Gordon growth model: The Gordon growth model is Labor force participation growth rate
preferred to use for developed economies in setting
long-run expectations. It can be expressed as: Sources of Expected rate of return on equity: The
expected rate of return on equity can be decomposed
D0 (1 + g ) D as follows:
E (Re) = + g = 1 + g = Dividend Yield +
P0 P0 1) Expected income return = D/P - ∆S
Capital gains Yield 2) Expected nominal earnings growth return = i + g
3) Expected repricing return = ∆PEP/E tends to
Where, increase when investors expect stocks to be less risky
E (Re) = the expected rate of return on equity in future. It is considered as the most volatile source of
D0 = Most recent annual dividend per share total return.
g = Long-term growth rate in dividends, assumed 4) Expected Capital gains return = Expected nominal
equal to the long-term earnings growth rate; earnings growth rate + Expected repricing return
P0 = Current share price
Reading 14 Capital Market Expectations FinQuiz.com

Example: Suppose the analyst estimates a 2% dividend Where,

yield, long term inflation of 3.2%, earnings growth rate of
a) Real risk-free interest rate is the single-period interest
4.5%, a repurchase yield of -0.5% and P/E re-pricing
rate for a completely risk-free security if no inflation
return of 0.35%.
were expected. It represents the compensation
demanded by investors for forgoing current
Expected return on the stock = 2.0% + 3.2% + 4.5% - 0.5%
consumption.
+ 0.35% = 9.55%

• The current real rate depends on cyclical factors.

• The long-term real rate depends on sustainable
Practice: Example 13 &14, equilibrium conditions.
Volume 3, Reading 14.
b) Inflation premium represents the compensation
demanded by investors for risk associated with
Fed Model: According to the Fed model, stock market is increase in inflation. It is typically a more volatile
overvalued (undervalued) when the market’s current component of bond yield.
earnings yield < (>) 10-year Treasury bond yield. The
earnings yield is a conservative estimate of the Inflation premium = Average inflation rate expected
expected return for equities because it is the required over the maturity of the debt +
rate of return for no-growth equities. For details, refer to Premium (or discount) for the
Reading 18. probability attached to higher
inflation than expected (or greater
3.1.2.2 Fixed-Income Markets disinflation)

Bonds are quoted in terms of a single discount rate, Or

referred to as yield to maturity or YTM. YTM is the
discount rate that equates the present value of the Inflation premium = Yield of conventional government
bond’s promised cash flows to its market price. bonds (at a given maturity) – Yield
on Inflation-indexed bonds of the
• Typically, YTM of a reference fixed-income security same maturity
(called bellwether) is used as a proxy for expected
rate of return on the bond. • Inflation premium varies depending on base
• YTM is a superior estimate for expected rate of return currency consumption baskets.
on the zero-coupon bond (i.e. bond with no
intermediate cash flows) because it assumes that as
c) Default risk premium represents the compensation
interest payments are received, they can be
demanded by investors for the risk of default of the
reinvested at an interest rate equal to YTM.
borrower.
• For callable bonds, yield-to-worst is sometimes used
as a conservative estimate of expected rate of
Default risk premium = Expected default loss in yield
return.
terms + Premium for the non-
diversifiable risk of default
3. The Risk Premium Approach: In the risk premium
approach, the expected return on a risky asset “i” is d) Illiquidity premium represents the compensation
computed as follows. demanded by investors for the risk of loss associated
with converting assets (particularly illiquid assets) into
E (Ri) = RF + (Risk premium)1 + (Risk premium)2 + …+ (Risk cash quickly. The illiquidity premium is positively
premium) K related to the illiquidity horizon e.g. the longer the
length of investment’s lock-up period for an
Where, alternative investment, the greater the illiquidity
E(Ri) = Asset’s expected return premium.
RF = Risk-free rate of interest
e) Maturity premium represents the compensation
NOTE: demanded by investors for higher interest rate risk
When assets are fairly priced, an asset’s required return = associated with longer-maturity debt.
Investor’s expected return.
Maturity premium = Interest rate on longer-maturity,
3.1.3.2 Fixed-Income Premiums liquid Treasury debt - Interest rate on
short-term Treasury debt
The expected bond return, E (Rb), can be estimated as
follows: f) A tax premium represents the compensation
demanded by investors for assuming risk of lower
E(Rb) = Real risk-free interest rate + Inflation premium + after-tax return due to higher tax rates.
Default risk premium + Illiquidity premium +
Maturity premium + Tax premium
Reading 14 Capital Market Expectations FinQuiz.com

3.1.3.3 The Equity Risk Premium World market portfolio: The global investable market
(GIM) can be used as a proxy for the world market
The equity risk premium is the compensation demanded
portfolio. GIM consists of traditional and alternative asset
by investors for assuming greater risk associated with
classes with sufficient capacity to absorb meaningful
equity relative to debt.
investment.
Equity risk premium = Expected return on equity (e.g.
An asset class risk premium (RPi) = Sharpe ratio of the
expected return on the S&P 500) –
world market portfolio × Asset’s own volatility × Asset
YTM on a long-term government
class’s correlation with the world market portfolio
bond (e.g. 10-year U.S. Treasury
bond return)
RPi = (RPM / σM) × σi × ρi,M
Thus,
Where,
Expected return on equity = YTM on a long-term RPM = Expected excess return
government bond + Equity σM = Standard deviation of the world market
risk premium portfolio
represents systematic or non-
diversifiable risk.
• It is known as Bond-yield-plus-risk-premium method.
Or

௜ =
4. Financial Market Equilibrium Models
Financial equilibrium models explain relationships
௜ ெ ௜ெ
between expected return and risk when financial market
is in equilibrium (i.e. where supply is equal to demand). ௜ ௠  = 
(௜ , ெ )/ெଶ ெ  =   × ெ 
ெଶ
ெ
Types of Financial Market Equilibrium Models: = ௜ ௜ெ  
ெ
Black-Litterman approach: The Black-Litterman
approach determines the equilibrium returns using a
• Commonly, 0.28 is used as an estimate of Sharpe
reverse optimization method i.e. “reverse engineering”
ratio of the GIM.
them from their market capitalization in relation to the
• The Sharpe ratio of the global market may change
market portfolio. It then incorporates investor’s own
with changes in global economic fundamentals.
views in determining asset allocations. For example, in
the absence of any investors’ views about a particular
asset class, market implied returns are used because its The Singer-Terhaar Approach: The ICAPM assumes that
equilibrium and optimal weights are identical. markets are perfect and as a result ignores market
imperfections. By contrast, the Singer-Terhaar approach
The international CAPM-based approach (ICAPM): takes into account the market imperfections, including
Under ICAPM, the illiquidity and market segmentation.

Expected return on any asset = Domestic risk-free rate + • Market integration: International markets are
Risk premium based on integrated when there are no impediments or
the asset’s sensitivity to barriers to capital mobility across markets. When
the world market markets are integrated, two identical assets with the
portfolio and expected same risk characteristics must have the same
return on the world expected return across the markets.
market portfolio in Types of Barriers:
excess of the risk-free a. Legal barriers i.e. restrictions placed by a national
rate. emerging market on foreign investment;
b. Cultural impediments;
Or c. Investor preferences;
• Market segmentation: International markets are
E (Ri) = RF +βi [E (RM) – RF] segmented when there are impediments to capital
Where, market movements. When markets are segmented,
two identical assets with the same risk characteristics
E(Ri) = The expected return on asset i given its beta
may have different expected returns (i.e. may trade
RF = Domestic Risk-free rate of return
at different exchange rate adjusted prices in
E(RM) = the expected return on the world market
different countries, violating the law of one price).
portfolio
o The more the market is segmented, the more it is
βi = the asset’s sensitivity to returns on the world
dominated by local investors;
market portfolio, = Cov (Ri, RM) / Var (RM)
• In practice, the asset markets are neither perfectly
segmented nor perfectly integrated. In other words,
Assumptions of ICAPM: Purchasing power parity
an asset market is partially segmented or integrated.
relationship holds, implying that the risk premium on any
currency equals zero.
Reading 14 Capital Market Expectations FinQuiz.com

In summary: Steps of estimating Expected Return using Calculations:

Singer-Terhaar Approach
Step 1: Bond Risk premium under completely integrated
markets = 8% × 0.45 × 0.28 = 1.008%
1. Separately estimate the risk premium for the asset
class using the ICAPM under two cases i.e. a perfectly
Equity Risk premium under completely integrated
integrated market and the completely segmented
markets = 16% × 0.65 × 0.28 = 2.912%
market.
Bond Risk premium under completely
• When a market is completely segmented, the segmented markets = 8% × 0.28 = 2.24%
reference market portfolio is the same as the
individual local market. Consequently, the ρi,M = 1. Equity Risk premium under completely
Risk premium for a perfectly segmented market = RPi segmented markets = 16% × 0.28 = 4.48%
 RPM 
= σ i ×   Step 2: Since there is no illiquidity premium, the bond
 σm  and equity risk premium will remain the same as
• The risk premium for a perfectly segmented market is calculated in step 1.
greater than that for the perfectly integrated
markets, all else equal. Step 3: The degree of integration is estimated to be 80%
• Note: For simplicity, it is assumed that the Sharpe or 0.80.
ratio of the GIM is equal to the Sharpe ratio of the
local market portfolio. Step 4: Final risk premium estimates are as follows.
Risk Premium (fixed income) = (0.80 × 1.008%) +
(0.20 × 2.24%) = 1.2544%
2. Add the applicable illiquidity premium, if any, to the
Risk Premium (equities) = (0.80 × 2.912%) + (0.20 ×
ICAPM expected return estimates (from step 1).
4.48%) = 3.2256%
3. Estimate the degree of integration of the given asset
Step 5: Expected return on bonds or equities = Risk-free
market. For example, it has been observed that
rate + relevant risk premium.
developed market bonds & equities are approx 80%
integrated and 20% segmented.
Expected return on bonds = 5% + 1.2544%
= 6.2544%
4. Estimate the risk premium assuming partial
Expected return on equities = 5% + 3.2256%
segmentation by taking a weighted average of risk
= 8.2256%
premium under perfectly integrated markets and risk
premium under perfectly segmented markets. The
Estimating the amount of illiquidity premium: The amount
weights represent degree of integration of the given
of illiquidity premium of an asset can be estimated using
asset market (from step 3).
investment’s multi-period Sharpe ratio (MPSR). MPSR
reflects investment’s multi-period return in excess of the
Risk premium of the asset class, assuming partial
return generated by the risk-free investment adjusted for
segmentation = (Degree of integration × Risk premium
risk. The MPSR must be calculated over the holding
under perfectly integrated markets) + ({1 - Degree of
period equal to lock-up period of investment.
integration} × Risk premium under perfectly segmented
markets)
Rule: The investor should invest in illiquid investment if it’s
MPSR at the end of the lockup period ≥ MPSR of the
5. Estimate the expected return on the asset class by
market portfolio.
adding the risk premium estimate (from step 4) to the
risk-free rate yields.
Illiquidity premium = Expected return of an illiquid asset –
Required rate of return on an illiquid asset at which its
Example:
Sharpe ratio is equal to that of market’s Sharpe ratio
Suppose
Covariance between any two assets = Asset 1 beta ×
• S.D. of Canadian bonds = 8% Asset 2 beta × Variance of the market
• S.D. of Canadian equities = 16%
• Correlation of Canadian bonds with GIM = 0.45 Where,
• Correlation of Canadian equities with GIM = 0.65  σ 1 × ρ (1, m) 
• Risk-free rate = 5% Beta of asset 1 =  
• Illiquidity premium = 0.  σ m 

 σ 2 × ρ (2, m) 
Beta of asset 2 =  
 σm 
Reading 14 Capital Market Expectations FinQuiz.com

output from such surveys largely depends on the

Practice: Example 18 &19,
professional identity of the respondent.
Volume 3, Reading 14.

3.3 Judgment

3.2 Survey and Panel Methods In a disciplined expectations-setting process, all the
assumptions and rationales used in the analysis must be
In the Survey method of capital market expectations explicitly documented by an analyst. In addition, the
setting, the analysts inquire a group of experts for their analyst must explicitly mention the judgments used in the
expectations and then use their responses in formulating analysis in an attempt to improve forecasts. The process
capital market expectations. When a group of experts of applying judgment can be formalized using a set of
provide fairly stable responses, the group is referred to as devices e.g. checklists.
a panel of experts and the method is called a panel
method. The limitation of survey method is that the

4. ECONOMIC ANALYSIS

According to the Asset-pricing theory, the risk premium vary considerably; hence, they are difficult to
of an asset is positively correlated with its expected forecast.
payoffs in a given economic condition. For example,
assets with high expected payoffs during periods of
The economic activity can be measured using the
weak consumption (business cycle troughs) tend to
following measures:
have lower risk premiums (implying higher prices)
compared to assets with low expected payoffs during
Gross domestic product (GDP): GDP represents the total
such periods.
value of final goods and services produced in the
economy during a given year.
An analyst who has greater ability to predict a change
in trend or point of inflection in economy activity and
GDP (using expenditure approach) =Consumption +
who has the ability to identify economic variables
Investment + Change in Inventories + Government
relevant to the current economic environment is
spending + (Exports - Imports)
considered to have a competitive advantage. The
inflection points are indicators of both unique investment
opportunities and source of latent risk. • Economists prefer to focus on Real GDP (i.e. increase
in the value of GDP adjusted for changes in prices)
Two major Components of Economic Growth: because it reflects the change in the standard of
living. The higher the real GDP, the greater the
1) Trend Growth: It identifies the long-term component of standard of living.
growth in an economy. It is relevant for setting long-
term return expectations for asset classes.
Output gap:
2) Cyclical Growth: It measures short-term fluctuations in Output Gap = Potential value of GDP (i.e. potential
an economy. Cyclical variation affects such variables output achieved if economy follows its
as corporate profits and interest rates etc. trend growth) – Actual value of GDP

4.1 Business Cycle Analysis • The output gap is positive (i.e. potential GDP >
actual GDP) during period of economic recession or
slow growth. Inflation tends to fall when output gap
There are two types of cycles associated with business
is positive.
cycle analysis:
• The output gap is negative (i.e. potential GDP <
actual GDP) during period of economic expansion
1) Short-term inventory cycle: This cycle typically lasts for
or fast growth. Inflation tends to rise when output
2-4 years.
gap is negative.
o When actual GDP growth rate > trend rate, it may
2) Longer-term business cycle: This cycle typically lasts
not give signs of overheating economy provided
for 9-11 years.
that unemployment is relatively high and there is
spare capacity in the economy.
• It is important to note that the duration and
amplitude of each phase of the cycle, as well as the
It is important to understand that real time estimates of
duration of the cycle as a whole are sensitive to
output gap may not necessarily always be accurate
major shocks in the economy (i.e. wars, petroleum or
because economy’s trend path is affected by changes
financial crisis, and shifts in government policy) and
in demographics and technology.
Reading 14 Capital Market Expectations FinQuiz.com

Recession: A recession refers to a broad-based confidence is at low levels;

economic downturn i.e. when an economy faces two • Inflation falls;
successive quarterly declines in GDP. • Output gap is still large & there is spare capacity;
• The recovery largely results from the simultaneous
4.1.1) The Inventory Cycle upswing in the inventory cycle;
The inventory cycle is a cycle that identifies fluctuations
in inventories. The inventory cycle results from adjusting Economic Policies:
inventories at desired levels in response to changes in
expected level of sales. • Stimulatory monetary policy i.e. interest rates fall;
• Stimulatory fiscal policy i.e. budgetary deficit grows;
Phases of Inventory Cycle:
A. Up phase: Future sales are expected to increase  Capital Market Effects:
leading to increase in production in an attempt to
increase inventories  overtime pay and • Government bond yields continue to fall in
employment increases to meet increasing production expectation of falling inflation and then start
needs  as a result, economy boosts and sales further bottoming;
increase. • Stock markets may perform well (i.e. stock prices
rise);
B. Down phase: After reaching some peak point
(referred to as inflection point), sales start falling
Attractive Investments:
and/or future sales are expected to fall (e.g. due to
tight monetary policy, higher oil prices etc.)
Consequently, production is cut back and inventory • Cyclical assets
level decreases. Due to reduction in production • Riskier assets i.e. small stocks, higher-yield corporate
layoffs, increase and/or hiring process slows down. As bonds, emerging market equities & bonds;
a result, economy slows down and sales further
decrease. 2. Early Upswing: The economy starts gaining
momentum. This phase is considered to be the
• Generally, after an inflection point, the inventory healthiest period of the cycle because of the
levels are adjusted to their desired levels within a absence of any inflationary pressure in the economy.
period of year or two. This phase usually lasts for at least a year and often
several years provided that growth is not too strong
and the output gap closes slowly.
Indicator of Inventory Position: The inventory position can
be gauged using “Inventory/sales ratio”. It is interpreted
as follows: • Confidence among businesses is increasing;
• Unemployment starts to fall as more workers are
hired in response to increased production & higher
• Falling inventory/sales ratio indicates that in the near
demand → consumer confidence starts rising → as
future, businesses will try to rebuild inventory; as a
a result, consumers borrow more and spending
result, economy is expected to strengthen in the
increases;
next few years.
• Inflation falls;
• Sharply rising inventory/sales ratio indicates that in
• Output gap is still large & there is spare capacity;
the near future, businesses will try to reduce
• The recovery largely results from the simultaneous
inventory; as a result, economy is expected to
upswing in the inventory cycle;
weaken in the next few years.
• Inventory levels build up in anticipation of future
increase in sales;
It is important to understand that due to improved • Capacity utilization increases → per unit cost falls →
techniques, i.e. “just-in-time” inventory management, profits rise rapidly;
inventory/sales ratio has been trending down.
Economic Policies:
4.1.2) The Business Cycle
The business cycle represents short-run fluctuations in • Central bank starts withdrawing stimulatory
GDP (i.e. level of economic activity) around its long-term monetary & fiscal policies introduced during
trend growth path. A typical business cycle is comprised recession;
of the following five phases:
Capital Market Effects:
1. Initial Recovery: The economy starts to grow from its
slowdown or recession. This phase lasts for few
months. • Short-term interest rates start rising;
• Longer-term bond yields may be stable or increase
slightly;
• Confidence among businesses starts to increase;
• Stock markets are rising;
• Unemployment is still high → thus, consumer
Reading 14 Capital Market Expectations FinQuiz.com

3. Late Upswing: During this phase, an economy tends to Attractive Investments:

grow rapidly and is likely to be overheated and face
inflationary pressures due to closing of output gap. • Interest-sensitive stocks i.e. utilities and financial
services;
• Confidence among businesses & consumers is still
rising; 5. Recession: Recession is associated with two
• Unemployment is low (i.e. economy is at or near full successive quarterly declines in GDP. This phase
employment); typically lasts for 6 months to a year.
• Due to shortages of labor supply → wages rise →
consequently, production costs & inflation starts to
• Businesses & consumers confidence decline
accelerate;
significantly;
• Profits fall sharply;
Economic Policies: • Production declines and inventory levels are
reduced considerably;
• Restrictive monetary policy i.e. interest rates • Business investment falls;
increase; • Consumer spending on luxury goods (i.e. car) fall;
• However, the policy is not severly restrictive as it aims • Unemployment rises sharply;
to cool down the economy rather than pushing • Inflation starts to fall;
economy into downturn; (known as "soft landing"). • Often associated with major bankruptcies, incidents
of uncovered fraud, or a financial crisis; as a result,
Capital Market Effects: lenders are reluctant to lend.

• Interest rates tend to rise due to heavy borrowing by Economic Policies:

consumers & businesses;
• Bond yields also tend to rise; • Stimulatory monetary policy i.e. interest rates fall;
o →Due to rising bond yields, bondholders incur however, very marginally initially;
capital losses.
• Stock markets may rise because higher inflation Capital Market Effects:
should be reflected in higher profits;
o but it is highly volatile, depending on the strength
• Both Short-term interest rates & longer-term bond
of boom because investors fear that inflation may
yields start falling;
be moving out of equilibrium.
• Stock markets start to improve in the later stages of
the recession;
4. Slowdown: The economy starts slowing down
primarily due to rising interest rates. During this phase,
Attractive Investments:
an economy is highly in danger of going into
recession. It lasts just a few months, or it may last a
year or more. • Bonds generate capital gains ;
• But, deteriorating credit quality may offset such
gains for some bonds;
• Confidence among businesses starts falling;
• Unemployment is still high → thus, consumer
confidence is at low levels & demand falls; The Yield Curve, Recessions, and Bond Maturity:
• Inflation is still rising despite slowdown in growth; The yield spread between the 10-year T-bond rate and
• Inventory levels are reduced due to cut back in the 3-month T-bill rate indicates expected future growth
production; in output.

Capital Market Effects: • Positive or widening yield spread between long-term

and short-term interest rates (i.e. a steepening or
• Short-term interest rates are high & rising; upward sloping yield curve) indicates an
• But, after reaching some peak point, they start falling expectation of an increase in real economy activity
→ indicating inverted yield curve; (economic upturn) because investors demand more
• As the yields fall afterwards, bonds rally sharply; yield as maturity extends if they expect rapid
• Stock markets may perform poorly as higher interest economic growth because of the associated risks of
rates will lead to slowing economic growth, resulting higher inflation and higher interest rates in the future,
in lower sales, revenues and profits; which can both hurt bond returns. When inflation is
In addition, as interest rates rise, the return on rising, the Federal Reserve will often raise interest
alternative investments increases and stocks become rates to fight inflation.
less attractive; o When yield spread is expected to narrow, it is
preferred to invest in shorter duration bonds;
• Conversely, negative or narrowing yield spread
between long-term and short-term interest rates (i.e.
Reading 14 Capital Market Expectations FinQuiz.com

a flattening or inverted yield curve) indicates an for long.

expectation of a decline in real economy activity
(economic downturn or recession) because an What happens when Interest Rates Reach Zero? Once
anticipation of a recession implies the expectation interest rates are at zero, the monetary authorities can
of a decline of future interest rates that is reflected in stimulate the economy using the following measures:
a decrease of long-term interest rates. In other
words, if investors expect a reduction of their 1) The central bank can push cash (bank “reserves”)
income, in case of a recession, they prefer to save directly into the banking system.
and invest in long-term bonds in order to get payoffs 2) The central bank can devalue the currency.
in the recession. Consequently, the demand for 3) The central bank can promise to keep short-term
long-term bonds increase, leading to a decrease of interest rates low for an extended period.
the corresponding yield. Further, to finance the 4) The central bank can buy assets directly from the
purchase of the long-term bonds, an investor may private sector (process called open market
sell short-term bonds whose yields will increase. As a purchase); as a result, spending increases as money is
result, when a recession is expected, the yield curve put directly into people’s hands and yields on these
flattens or gets inverted.. assets fall.
o When yield spread is expected to widen, it is
preferred to invest in longer-duration bonds; Price indices are used to identify the overall trend in
prices. For example,
4.1.3) Inflation and Deflation in the Business Cycle
Inflation refers to continuous (not one time) increase in • Consumer price index: It is calculated using a basket
aggregate price level, resulting in decrease in the of goods and services based on consumers’
purchasing power of a unit of currency. Inflation is linked spending patterns.
to business cycle i.e. • GDP and consumer expenditure deflators: They are
used to adjust or deflate the nominal series for
inflation.
• It tends to increase during late stages of a business
cycle when there is no output gap which puts
upward pressure on prices. Three principles of Central bank Policy regarding
• It tends to fall during recessions and the early stages inflation:
of recovery when there is a large output gap which
puts downward pressure on prices. A. Central banks’ policy-making decisions must be free
from political influence; otherwise, central banks may
use easy monetary policy which leads to increase in
Deflation refers to continuous (not one time) decrease in
inflation over time.
aggregate price level, resulting in increase in the
B. Central banks should have an inflation target which
purchasing power of a unit of currency. It negatively
serves dual roles i.e. act as a disciplining tool for
affects the economy in two ways:
central bank itself and as a signal of central bank’s
intention to the market. It also helps to anchor market
i. Deflation tends to reduce the value of debt-financed
expectations.
investments because when the price of a debt-
C. Central banks should use monetary policy (primarily
financed asset falls, the value of the “equity” in the
interest rates) to manage the economy and to
asset (i.e. asset’s value - loan balance) tends to
prevent it from either overheating or suffering from a
decline at a leveraged rate. E.g. if the value of a
recession for too long.
property financed with 67% loan-to-value mortgage
decreases by 5%, the value of equity in the property
will fall by = 5% / (1 – 0.67) = 5% / 0.33 = 15.15%.
ii. Deflation tends to undermine central bank’s ability to Practice: Example 24,
affect monetary policy to control the economy: Volume 3, Reading 14.
During deflation, interest rates are near to zero; as a
result, the central bank is unable to stimulate the
economy with monetary policy (i.e. by lowering
interest rates below zero). 4.1.4) Market Expectations and the Business Cycle
It is quite difficult to identify the current phase of the
• Therefore, in order to keep inflation at low level but cycle and correctly predict the starting time of the next
without pushing the economy into deflation, central phase because the phases of the business cycle vary
banks prefer to use a low positive rate of target substantially in length (duration) and amplitude
inflation. (intensity): For example,
• An economy may suffer from a prolonged deflation
when its money supply is restricted; e.g. in gold • Recessions can be steep with a huge decline in
standard currency system, the money supply was output and a substantial rise in unemployment; or it
restricted by the size of a government’s gold can be short lived with only a small decline in output
reserves. By contrast, when the money supply can and only a modest rise in unemployment.
be easily expanded, deflation does not tend to last
Reading 14 Capital Market Expectations FinQuiz.com

• Weak phase of the business cycle may involve only are positive;
a slower economic growth or a “growth recession”
rather than a recession. This particularly occurs
when:
o An economy has a rapid trend rate of growth;
o The upswing was relatively short or mild without
bubble or severe overheating in the stock market
or property market;
o Inflation is relatively low;
o The world economic and political environments

Real Estate/Other Real

Cash Bonds Equity
Assets
Inflation at or below Short-term yields Yield levels Bullish while market is Cash flow steady to
expectations steady or declining. maintained; Market is in equilibrium state. rising slightly.
(Neutral) in equilibrium. (Positive) Returns equate to
(Neutral) long-term average.
Market in general
equilibrium.
(Neutral)
Inflation above Bias toward rising Bias toward higher High inflation is Asset values
expectations rates. yields due to a higher negative for financial increasing; increases
(Positive) inflation premium. assets. Less negative cash flows and higher
• As yields ↑, nominal for companies/ expected returns.
bond price ↓; also, industries able to pass (Positive)
bond coupon & on inflated costs.
principal become (Negative)
less attractive on
real basis;
(Negative)
Deflation Bias toward 0% Purchasing power Negative wealth Cash flows steady to
short-term rates. increasing. effect slows demand. falling. Asset prices
(Negative) Bias toward steady to Especially affects face downward
lower rates (may be asset-intensive, pressure.
offset by increased commodity- (Negative)
risk of potential producing (as
defaults due to falling opposed to
asset prices). commodity-using),
(Positive) and highly levered
companies.
(Negative)
Source: Curriculum, Reading 14, Exhibit 18.

4.1.5) Evaluating Factors that Affect the Business Cycle spending largely depends on consumer income
In formulating capital market expectations, the business after tax which in turn depends on wage
cycle analysis should be performed by focusing on the settlements, inflation, tax changes, and employment
following four areas: growth. In addition, consumer spending can also be
affected by unusual weather or holidays.
1) Consumer spending: The consumer spending • Assuming household savings rate constant, ∆ in
represents 60-70% of GDP in most large developed income = ∆ in consumer spending
economies. Thus, it is regarded as the most important
business cycle factor. Unlike business investments, it is 2) Business investment: Business investment represents a
quite stable over the business cycles. smaller % of GDP relative to consumer spending.
Business investment and spending on inventories are
• Sources of data on consumer spending: Retail sales, regarded as the most volatile business cycle factor.
miscellaneous store sales data, consumer • Sources of data on business investments: Purchasing
confidence survey data (indicates changes in managers index (PMI) which is based on answers to
household’s saving rates), and consumer a series of questions about the company’s position,
consumption data. including production plans, inventories, prices paid,
• Factor that affects consumer spending: Consumer prices received, and hiring plans.
Reading 14 Capital Market Expectations FinQuiz.com

o Rising inventory levels during early stages of an which the potential growth of the economy is in balance
inventory cycle upswing may indicate that with target inflation rate. E.g. if the target inflation rate is
businesses are spending on inventories as they 2% and economic growth is 2.5%, the neutral level of
expect sales to increase in future, reflecting higher interest rates = 2% + 2.5% = 4.5%.
economic growth.
o Rising inventory levels during late stage of the The Taylor Rule: This rule relates a central bank’s target
inventory cycle may indicate that inventory levels short-term interest rate to the rate of growth of the
are increased due to lower than expected sales. economy and inflation.

Taylor rule equation:

3) Foreign trade: For large economies (e.g. U.S. &
Japan), this factor represents a smaller % (i.e. 10-15%)
Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)]
of GDP and therefore, considered as a less important
+ [0.5 × (Iforecast – Itarget)]
factor; whereas for smaller economies foreign trade is
an important factor, representing 30-50% of GDP, in
Where,
general.
Roptimal = the target for the short-term interest rate
4) Government Policy: Both the government and Rneutral = the short-term interest rate that would be
monetary authorities tend to control the growth rate targeted if GDP growth were on trend and
of the economy to keep it close to its long-term inflation on target
sustainable trend rate and attempt to meet inflation GDPgforecast = the GDP forecast growth rate
target using different policies i.e. GDPgtrend = the observed GDP trend growth rate
Iforecast = the forecast inflation rate
• Monetary policy: Easy (tight) monetary policy Itarget = the target inflation rate
involves reducing (increasing) short-term interest
rates and/or increasing (decreasing) money supply. Interpretation of Taylor Rule: When forecast GDP growth
Easy (tight or restrictive) monetary policy is used rate and/or the forecast inflation rate >(<) trend or
when the economy is weak (in danger of target level, central bank must increase (reduce) the
overheating). short term interest rates* by half the difference between
o Over the long-run, the growth in money supply and the forecast and the trend or target.
the growth in nominal GDP are positively related
i.e. as money supply increases, nominal GDP *Commonly, the federal funds rate, or fed funds rate
increases, leading to increase in inflation. which is the interest rate on overnight loans of reserves
o Monetary policy focuses on key variables, (deposits) at the Fed between Federal Reserve System
including the pace of economic growth, amount member banks.
of excess capacity still available (if any),
unemployment level, and inflation rate.
• Fiscal policy: Easy (tight) fiscal policy involves Practice: Example 26 & 27,
reducing (increasing) tax rates and/or increasing
Volume 3, Reading 14.
(decreasing) governmental spending.

4.1.5.3 Monetary Policy

4.1.5.4 Fiscal Policy
Mechanisms through which change in short-term interest
rates affects the economy include: Fiscal policy refers to the deliberate manipulation of the
budget deficit (government spending > taxes) in order
to influence the economy.
• Borrowing and lending effects: As short-term rates ↓,
borrowing by consumers and businesses ↑. (Due to
decline in interest rates, corporation’s cost of capital • Easy or expansionary fiscal policy involves increasing
decreases). government spending and/or reducing taxes to
• Capital markets effects: As short-term rates ↓, bond stimulate the economy.
and stock prices ↑. Consequently, consumer • Tight or restrictive fiscal policy involves decreasing
spending and business investment further rise. government spending and/or increasing taxes to
• Foreign Trade effects: As short-term rates ↓
the slow the economy.
exchange rate ↓
currency depreciates in value

leading to increase in exports. Following two factors must be considered in analyzing
the fiscal policy:
It must be stressed that impact of changes in interest
rates not only depends on the direction of change, but 1) Changes in the governmental budgetary deficit: It is
also on the absolute level of interest rates compared to important to focus on the changes in the
their average or “neutral” level. governmental budgetary deficit rather than its
absolute level. E.g. when budget deficit increases
Neutral level of Interest Rates: The “neutral level” of (decreases), it implies easy (tight) fiscal policy.
interest rate is the equilibrium short-term interest rate at
Reading 14 Capital Market Expectations FinQuiz.com

2) Deliberate changes in the budget deficit: It is or when the economy grows), tax revenues ↓ (↑) and
important to focus only on the deliberate changes in government spending on unemployment ↑ (↓);
the budget deficit in response to changes in fiscal consequently, budget deficit tends to increase
policy rather than changes in budget deficit in (decrease).
response to the changes in economy, e.g. during
recessions or when the economy is slow (expansions

Linkages with Monetary Policy

• Economy is expected to slow

Tight Fiscal Policy
+ Tight Monetary Policy
= • Yield curve tends to be inverted in
shape.
• Economy is expected to grow
Expansionary Fiscal Policy
+ Expansioary Monetary
Policy = • Yield curve tends to be steeply
upward sloping
• Ambiguous situation i.e. unlear
Expansionary Fiscal Policy
+ Tight Monetary Policy
= whether economy will slow or grow
• Yield curve tends to be flat.
• Ambiguous situation i.e. unlear
whether economy will slow or grow
Tight Fiscal Policy
+ Expansioary Monetary
Policy = • Bond yields tend to fall &Yield curve
tends to be moderately upward
sloping

4.2 Economic Growth Trends Practice: Example 28,

Volume 3, Reading 14.
Economic Growth Trend: The long-term, smooth growth
path of GDP is called the economic growth trend. It
reflects the average growth rate around which the
4.2.1) Consumer Impacts: Consumption and Demand
economy rotates (i.e. slows down or grows) in response
to business cycles but is independent of business cycle. Consumption represents the largest source of aggregate
In other words, it represents the pace of growth of economic growth in both developed and developing
economy over a number of years without any economies. It is also the most stable or even
unsustainable increase in inflation. countercyclical business cycle factor as explained by
the permanent income hypothesis.
The economic growth trend is determined by other
economic trends, including: Wealth effect: When % increase in consumers’ spending
is greater than % increase in consumers’ wealth
• Population growth and demographics (income), it is referred to as the wealth effect.
• Business investment and productivity
• Governmental structural policies The permanent income hypothesis: According to the
• Inflation/deflation permanent income hypothesis, consumer spending
• Health of banking/lending processes behavior is largely determined by long-term income
expectations rather than temporary or unexpected (or
one-time) change in income/wealth.
The expected trend rate of economic growth is a key
input in discounted cash flow models of expected
return. • When income temporarily increases (i.e. during
expansions), increase in spending will be less than
increase in income.
• The higher the trend rate of economic growth of a
• When income temporarily decreases (i.e. during
country, the more attractive returns for equity
recessions), decrease in spending will be less than
investors.
decrease in income.
• The higher the trend rate of economic growth of a
country, the more fast an economy can grow
without any unsustainable increase in inflation.
Reading 14 Capital Market Expectations FinQuiz.com

4.2.2) A Decomposition of GDP Growth and Its Use in

Forecasting 2. The public sector has minimal interference with the
private sector: There should be minimal government
Trend growth in GDP = Growth from labor inputs + intervention in the economy because excessive
Growth from changes in labor government intervention, particularly in the form of
productivity regulations, creates inefficiency and leads to a
misallocation of scarce resources. For example, labor
Where, market rules tend to increase the structural level of
unemployment (i.e. unemployment resulting from
Growth from labor inputs reflects growth from changes in
scarcity of a factor of production).
employment.
3. Competition within the private sector is encouraged:
Growth from labor inputs = Growth in potential labor
Competition within the private sector makes the
force size + Growth in actual
companies more efficient and consequently
labor force participation
increases productivity growth of an economy.
Government policies that encourage competition
Growth from changes in labor productivity =
within the private sector include reduction of trade
Growth from capital inputs + TFP growth*
tariffs and barriers, removal of restrictions on foreign
investment etc. However, due to higher competition it
*TFP growth = Growth associated with increased
becomes difficult to earn high returns on capital; as a
efficiency in using capital inputs.
result, stock market valuations decrease.

4. Infrastructure and human capital development are

Impact of rate of investment on stock market returns: supported: Governments must pursue infrastructure
and human capital development (i.e. education &
The stock market returns depend on the rate of return on
health) projects because they have important
invested capital i.e. the higher the rate of investment

economic benefits.
the higher the growth in capital
the lower the returns
on invested capital; consequently, the lower the stock
5. Tax policies are sound: Sound tax policies involve
market returns (despite higher rate of economic growth).
simple, transparent, stable and low marginal tax rates,
and a very broad tax base. Generally, taxes represent
30-50% of GDP in many developed economies.
Practice: Example 29,
Volume 3, Reading 14. 4.3 Exogenous Shocks

In general, it is relatively easy to forecast trends than

4.2.3) Government Structural Policies cycles because they are relatively constant over time.
Therefore, trends or changes in trends are already
Government structural policies are the government
discounted in market expectations and prices by
policies that affect the limits of economic growth and
investors.
incentives within the private sector.
However, some trends are not forecastable. These are
Elements of pro-growth government structural policy:
referred to as “exogenous shocks” e.g. short-lived
1. Fiscal policy is sound: Regularly running a large political events, wars, abrupt changes in government tax
budget deficit does not indicate a sound fiscal policy. or trade policies, sudden collapse in an asset market or
A sound fiscal policy is the one in which budget in an exchange rate, natural disasters etc.
deficit is close to zero over the long-run. Following are
the three problems associated with running large Two major types of economic shocks with contagion
budget deficits on a consistent basis: effects include:

i. Twin deficits problem and currency devaluation: 1) Oil shocks (section 4.3.1): Oil shocks refer to a sharp
An economy may need to borrow from abroad to increase in the price of oil, which reduces consumer
finance its budget deficit, that is, by running purchasing power and creates higher inflation. Over
current account deficit. When level of foreign debt time, as employment falls and economy slows down,
rises considerably, an economy needs to reduce the output gap opens up; consequently, inflation
borrowing, usually through devaluing its currency. decreases to its previous level.
ii. Higher inflation: If the budget deficit is financed by
printing money, it results in higher inflation in the 2) Financial shocks (section 4.3.2): Financial shocks are
economy. associated with country’s inability to meet debt
iii. Crowding-out effect: Government borrowing to payments, devaluation of currency, and considerable
finance budget deficit puts upward pressures on decline in asset prices, (particularly real estate prices).
interest rates. The higher interest rates can cause Usually, banks are highly vulnerable to financial
lower private sector spending and investment. shocks. Financial shocks reduce economic growth
Reading 14 Capital Market Expectations FinQuiz.com

either directly through decreased bank lending or • Strong private sector economy (reflecting strong
through decreased investor confidence. Financial demand for world savings)
crises are potentially more dangerous in a low interest • Tight monetary policy
rate environment because during such environment,
the central bank is unable to further reduce interest
4.4.3) Emerging Markets
rates for the purpose of providing sufficient liquidity in
the economy. 4.4.3.1 Essential Differences between Emerging and
Major Economies
4.4 International Interactions
• Emerging countries need higher rates of investment
in physical capital and infrastructure and in human
Small countries with concentrated economies
capital than developed countries.
(depending on a few commodities) tend to be highly
• Due to inadequate domestic savings (unlike
influenced by developments in other economies in the
developed countries), emerging countries heavily
world compared to large countries with diverse
depend on foreign capital (i.e. foreign debt).
economies (e.g. U.S.). However, international
• Emerging countries tend to have a highly volatile
interactions among countries in the world have
political and social environment than developed
increased with increase in globalization of trade, capital
countries, which makes it difficult to achieve
flows, and direct investment.
structural reforms.
• Emerging countries tend to have a relatively large %
Types of International Interactions: of people with low income and few assets and a
relatively small middle class.
1) Macroeconomic Linkages: Economies are linked
• Emerging countries tend to have concentrated
through two broad channels
economies e.g. with particular commodities or in a
narrow range of manufactured goods.
• Trade in goods and services: For example, as foreign • Due to heavy reliance on oil imports, emerging
demand for exports increase, the exports increase
countries tend to be more sensitive to fluctuation in
aggregate demand increase and consequently, oil prices or rely heavily on continuing capital inflows.
economic growth increases. • Emerging countries tend to have excessive short-
• Finance: As international investors shift their assets term debt.
around the world, they link asset markets here and
abroad, it affects income, exchange rates, and the
4.4.3.2 Country Risk Analysis Techniques
ability of monetary policy to affect interest rates.
• For emerging countries’ bonds, investors focus on
2) Interest Rate/Exchange Rate Linkages: These linkages assessing the risk of default of the country.
affect countries that unilaterally peg their currencies • For emerging countries’ stocks, investors focus on
firmly or loosely to one of the major currencies (e.g. the assessing the growth prospects of emerging
U.S. dollar). The pegging exchange rates policy has countries and their sensitivity to surprises.
two benefits:
Key Elements of Country Risk Analysis:
i. It reduces the volatility of the exchange rate (at
least in the short-run). 1. Soundness of fiscal and monetary policy: Persistently
ii. It enables the pegged country to control inflation. large budget deficits tend to reduce economic
iii. It imposes some discipline on government policies. growth. In addition, the larger and the more persistent
the fiscal deficit, the greater the debt. The soundness
Limitations of pegging exchange rate policy: of fiscal policy is assessed through ratio of fiscal deficit
to GDP i.e.
i. It can introduce currency speculation.
ii. In pegging exchange rate regime, the level of
• When ratio of fiscal deficit to GDP is persistently > 4%,
domestic interest rates will depend on overall
it is regarded as risky, indicating substantial credit
market confidence in the peg i.e. the higher
risk;
(lower) the confidence in the exchange rate peg,
• When ratio of fiscal deficit to GDP is between 2-4%, it
the lower (higher) the interest rate differential
is acceptable but still risky.
(bond yields of pegged country – bond yields of
• When ratio of fiscal deficit to GDP < 2%, it is regarded
the major currency country).
as safe.
• Ratio of debt to GDP > 70-80% is regarded as
Bond yields of the country with undervalued
extremely dangerous.
(overvalued) exchange rate tend to be lower (higher).

NOTE: 2. Economic growth prospects for the economy:

Real and nominal rates tend to be high when there is:

• Annual growth rates of < 4% is not favorable
because it indicates that the country is slowly
• Increasing Budget deficit catching up with the industrial countries and per
Reading 14 Capital Market Expectations FinQuiz.com

capita income is growing very slowly or even falling. indicates safe level.
• The structural health of an economy can be gauged o Ratio of foreign reserves to short-term debt < 100%
using the Economic Freedom Index, an index based indicates risky level.
on a range of indicators of the freedoms enjoyed by
the private sector i.e. tax rates, tariff rates, and the 6. Political situation in relation to the required policies:
cost of setting up companies. Higher value of
Economic Freedom Index indicates greater
• Political situation must be supportive of the required
economic growth.
structural reforms and policies (i.e. privatization and
the ending of monopolies).
3. Degree of competitiveness of Currency and the level • Strong and less volatile political environment is highly
of external accounts: important for countries with weak economy, slow
growth, slow policy liberalization, high debt and low
• When currency stays overvalued for a prolonged reserves.
time period it indicates increase in external debt and
large current account deficit. Also, an overvalued
and highly volatile currency negatively affects 4.5 Economic Forecasting
business confidence and investment.
• The sustainability of the external accounts can be Following are the three economic forecasting
measured using size of the current account deficit approaches:
i.e.
o Ratio of current account deficit to GDP persistently 1) Econometric Modeling: This method is a formal and
> 4% is regarded as risky. mathematical approach to economic forecasting as
o Ratio of current account deficit to GDP between it involves use of econometric models. Econometric
1-3% is regarded as sustainable provided that a model comprises equations, which seek to model the
country is growing. relationships between different economic variables
o A current account deficit is less sustainable when it based on some sound economic theory to forecast
is financed through debt because it will likely lead the future. E.g.
to currency depreciation and economic
slowdown. As the economy slows down
imports GDP Growth = α + β1Consumer spending growth +
fall
current account deficit is reduced. β2Investment growth
o A current account deficit is more sustainable when
it is financed through foreign direct investment Consumer spending growth = α + β1Lagged consumer
because foreign direct investment creates income growth +
productive assets. β2Interest rate

4. The level of external debt: External debt is the foreign Investment growth = α + β1Lagged GDP growth +
currency debt owed to foreigners by both the β2Interest rate
government and the private sector. It serves to fund
the savings deficit resulting from insufficient domestic • Econometric models vary from small models with just
savings. The sustainability of the external debt can be one equation or complex models with hundreds of
measured using equations.
• It must be stressed that larger models with multiple
• Ratio of foreign debt to GDP i.e. variables are not necessarily superior to smaller
o Ratio of foreign debt to GDP > 50% indicates risky models.
level.
o Ratio of foreign debt to GDP between 25-30% is Strengths of Econometric modeling:
regarded as the ambiguous level.
• Ratio of debt to current account receipts i.e. • Econometric models can be quite robust and may
o Ratio of debt to current account receipts > 200% provide forecasts close to reality.
indicates risky level. • Econometric models consolidate existing empirical
o Ratio of debt to current account receipts < 100% and theoretical knowledge of how economies
indicates safe level. function.
• Econometric models provide quantitative estimates
5. Level of liquidity: Liquidity refers to level of foreign of the effects of changes in exogenous variables on
exchange reserves compared to trade flows and the economy.
short-term debt (debt with maturity of < 12 months). • Econometric models help to explain their own
failures, as well as provide forecasts and policy
• Adequate level of foreign exchange reserves is advice.
regarded as equal to the value of three months’ • Econometric models restrict the forecaster to a
worth of imports. certain degree of consistency.
• Ratio of foreign reserves to short-term debt i.e. • Econometric models are useful to forecast
o Ratio of foreign reserves to short-term debt > 200% economic upturns/expansions.
Reading 14 Capital Market Expectations FinQuiz.com

• Econometric models can be modified readily to

accommodate changing conditions. Diffusion index: Diffusion index is a measure that reflects
number of upward trending indicators and downward
trending indicators. E.g. if 8 out of 10 indicators are
Limitations of Econometric modeling:
exhibiting downward trend, it indicates that an
economy is likely to contract.
• Econometric models may be quite complex and
time-consuming to build; difficult to implement; and General rule: Three consecutive months of increases
expensive to maintain. (decreases) in LEIs give signals of upturn (downturn) in
• Econometric models are not useful to forecast the economy within three to six months.
recessions.
• Econometric models depend on adequate Strengths of Economic Indicators:
measures for the real-world activities and
relationships to be modeled, data on which may not
• They are usually intuitive and simple to construct.
be easily available.
• They are easily available from third parties.
• Variables in the econometric models may be
• They can be easily tailored according to individual
measured with error.
needs.
• Econometric models assume constant relationships
• A literature suggests that they are effective in
among variables; hence, they may be misspecified
assessing outlook of an economy.
when relationships change over time due to
changes in the structure of the economy.
• Econometric models need forecasters to conduct Limitations of Economic Indicators:
careful analysis of output.
• It has been observed in the past that they are not
2) Economic Indicators: Economic indicators are effective on a consistent basis due to changes in the
economic statistics provided by government and relationships between inputs.
established private organizations. They provide • They may provide false signals.
information on an economy’s recent past activity or • Some data series are reported with a lag.
its current or future position in the business cycle. • Some data series are subject to revisions.

Types of Economic Indicators: Following are the three U.S. Composite Indices
types of economic indicators.
Leading Index
A. Leading Economic Indicator (LEI): LEIs are indicators 1. Average weekly hours, manufacturing
that change before the change in the economy i.e. 2. Average weekly initial claims for unemployment
they tend to exhibit declining (rising) trend before the insurance
economy declines (rises), e.g. stock market returns. 3. Manufacturers’ new orders, consumer goods and
They reflect future economic activity and therefore materials
help to predict the future performance of economy. 4. Vendor performance, slower deliveries diffusion
They are regarded as the most important type of index
economic indicators for investors. Leading indicator- 5. Manufacturers’ new orders, non-defense capital
based analysis is the simplest forecasting approach goods
because it involves only a limited number of variables. 6. Building permits, new private housing units
7. Stock prices, 500 common stocks Financial
B. Coincident Economic Indicator: Coincident 8. Money supply, M2 components; All else
economic indicators are indicators that change 9. Interest rate spread, 10-year Treasury are non-financial
bonds less federal funds components
simultaneously with the economy, e.g. GDP. They
reflect current economic activity. 10. Index of consumer expectations
Coincident Index
C. Lagging Economic Indicator: Lagging economic 1. Employees on nonagricultural payrolls
indicators are indicators that change with some time 2. Personal income less transfer payments
lag with the change in the economy (i.e., a few 3. Industrial production
months after the economy does). E.g. unemployment 4. Manufacturing and trade sales
rate tends to fall after a few months of economic
growth. They reflect recent past economic activity. Lagging Index
1. Average duration of unemployment
Composite LEIs or LEI index: Composite LEIs is a 2. Inventory/sales ratio, manufacturing and trade
collection of economic data releases that reflect an 3. Labor cost per unit of output, manufacturing
overall future performance of the economy. 4. Average prime rate
5. Commercial and industrial loans
• Compared to individual leading indicators, LEI index 6. Consumer installment credit to personal income ratio
is less useful for predicting the economic activity 7. Consumer price index for services
because some of its components are already public.
Reading 14 Capital Market Expectations FinQuiz.com

3) Checklists Approach: This method involves subjective

integration of the answers to a set of relevant • Analyzing exchange rate competitiveness and
questions. The information gathered through answers recent movements;
can be extrapolated into forecasts in two ways i.e. • Assessing strength of economic growth;
objective statistical methods (i.e. time series analysis)
or subjective or judgmental means to assess the
Reviewing government’s fiscal stance;
outlook for the economy.
Reviewing monetary stance i.e.
Strengths of Checklists approach:

• Recent changes in interest rates;

• It is a simple and straightforward method.
• Trend in real interest rates;
• It provides flexibility as the forecaster is allowed to
• Level of current interest rates in relation to the rate
quickly incorporate structural changes in the
under Taylor rule;
economy by changing the variables or the weights
• Monetary conditions indices i.e. trends in asset prices
assigned to variables within the analysis.
and exchange rate;
• Money supply indicators;
Limitations of Checklists approach:
What is the trend of Inflation? i.e. is it rising or falling;
• It is time-consuming because it requires analysis of
broad range of data.
• It depends on subjective judgment.
• It is based on a process, which is manual in nature Practice: Example 30,
which makes it difficult to use for modeling complex Volume 3, Reading 14.
relationships.

Guideline Set of Questions used to assess the outlook of Using Economic Information in Forecasting Asset
the economy: 4.6
Class Returns
What is the position of the economy in the business
4.6.1) Cash and Equivalents
cycle? It is judged by analyzing
Cash includes short-term debt (e.g. commercial paper)
• Previous data on GDP growth and its components; with maturity of less than or equal to one year.
• Degree of unemployment relative to estimates of
“full employment” and its trend i.e. declining or • Given no change in overnight interest rates, longer-
increasing; maturity paper tends to pay higher interest rate than
• Output gap; shorter-maturity paper because of greater risk of loss
• Businesses’ inventory position; associated with their long-term maturity.
• Level of inflation relative to target and its trend i.e. • When overnight interest rates are expected to
rising or declining; increase over time, then longer-maturity paper tends
to pay even higher rates than shorter-term paper.
How strong is the consumer spending? It is judged by
analyzing Investment strategy during rising interest rate period:
During periods of rising short-term rates, an investment
• Wage/income patterns; strategy of buying shorter-maturity paper is preferred
• Pace of growth of employment; because it is profitable to reduce the duration of bond
• Consumers’ level of confidence i.e. using consumer portfolio when the yield curve is upward sloping.
confidence indices;
Investment strategy during declining interest rate period:
During periods of declining short-term rates, an
How strong is the business spending? It is judged by
investment strategy of buying longer-maturity paper is
preferred because it is profitable to increase the
• Reviewing survey data i.e. purchasing managers duration of bond portfolio when the yield curve is flat or
indices; inverted.
• Reviewing recent capital goods orders;
• Assessing balance sheet health of companies;
• Assessing cash flow and earnings growth trends; Practice: Example 31,
• Assessing trend of stock market i.e. is it rising or Volume 3, Reading 14.
falling;
• Reviewing inventory position i.e. low inventory/sales
4.6.2) Nominal Default-Free Bonds
ratio implies GDP strength;
Nominal default-free bonds are conventional bonds with
What is the degree of import growth? It is judged by zero or minimal default risk.
Reading 14 Capital Market Expectations FinQuiz.com

• Default-risk-free bonds have zero credit spread or 1) Economic Growth: When the economy is strong
default risk premium. (weak), real yields are high (low)
consequently, real
• Relative value of default-risk-free bonds depends on yields on inflation-indexed bonds will be higher
real yields and inflation i.e. (lower).
o If inflation is expected to increase rapidly
market 2) Inflation expectations: Inflation-indexed bonds
yields ↑
consequently, value of default-risk-free provide hedge against inflation risk. Hence, the higher
bonds will fall below par value. (lower) the inflation and the more (less) volatile it is,
o When an economy is expected to grow strongly
the greater (lower) the value of indexed bonds in
demand for capital ↑ as well as inflation ↑
as a providing protection against inflation risk and
result, bond yields rise (prices fall). consequently, the lower (higher) the yields on
o Changes in short-term rates have uncertain effects inflation-indexed bonds.
on bond yields:
 Typically, as short-term rates increase
longer- 3) Supply of indexed bonds versus investors’ demand for
term bond yields also increase (bonds price fall). indexed bonds: When investors’ demand for indexed
 Sometimes, as short-term rates increase bonds is greater (lower) than supply, yields on

economy slows down
as a result, longer-term inflation-indexed bonds are lower (higher). The real
bond yields tend to fall (bonds price increase). yield is also affected by tax effects and the limited
o When bond markets have confidence on the size of the market.
ability of central banks to achieve inflation targets,
then changes in inflation tend to have no impact 4.6.6) Common Shares
on bond yields. 4.6.6.1 Economic Factors Affecting Earnings
Over the long-run, the trend growth in aggregate
4.6.3) Defaultable Debt
company earnings is positively correlated with the trend
Defaultable debt (mostly corporate debt) is debt with a rate of growth of the economy i.e. the higher (lower) the
substantial amount of credit risk. growth of the economy, the greater (lower) the average
earnings growth because:
• Credit spreads on defaultable bonds tend to widen
during recessions because default rates tend to • During the early stages of an economy upswing
increase when economic growth slows down and
capacity utilization rises and employment
business conditions weaken. As the credit spreads increases; however, the wages are still not higher
increase
bond yields increase. due to relatively high unemployment
as a result,
• Credit spreads on defaultable bonds tend to narrow profits are higher and earnings are strong. During
during expansions because when default rates tend later stages of an economy upswing
wages start
to decline there is strong economic growth and to increase quickly
profits are reduced and
strong business conditions. As the credit spreads earnings growth slows down.
reduce
bond yields decrease. • During recessions
sales reduce, capacity utilization
is low
earnings are depressed.
4.6.4) Emerging Market Bonds
Important to Note:
Emerging market debt is the sovereign debt of non-
developed countries. Emerging market debt is
denominated in foreign currency; as a result, it tends to • Equity returns are positively affected by accelerating
have higher risk of default. The risk of emerging market economic growth, decreasing interest rates and
bonds is assessed in terms of their spread over domestic strong growth in consumer and business sector.
Treasuries compared to similarly rated domestic • Cyclical industries (with large fixed costs and a
corporate debt. pronounced sales cycle) tend to have higher
sensitivity to business cycles, e.g. car manufacturers
4.6.5) Inflation-Indexed Bonds and chemical producers.
• The sales, earnings, and dividends of “Pro-cyclical”
Inflation-indexed bonds are bonds that pay a fixed industries tend to have large positive correlation with
coupon (the real portion) plus an adjustment equal to GDP.
the change in consumer prices. For example, Treasury • When an industry’s earnings have higher correlation
Inflation-Protected Securities (TIPS) in the U.S. and Index- with inflation and interest rates, it has a higher ability
Linked Gilts (ILGs) in the U.K. to pass through to customers the increased costs of
higher inflation and interest rates.
• Inflation-indexed bonds are perfectly risk-free assets • Export-oriented companies perform well when
because they have no risk from unexpected domestic currency depreciates.
inflation. • Companies with higher (lower) earnings growth rate
• Nevertheless, the yield on inflation-indexed bonds is during recessions tend to have higher (lower)
not constant and change over time in response to valuations.
the following three economic factors:
Reading 14 Capital Market Expectations FinQuiz.com

4.6.8) Currencies
Practice: Example 32 & 33,
Volume 3, Reading 14. Exchange rate is affected through various channels i.e.
Trade: All else being constant, when imports of a country
4.6.6.2 The P/E Ratio and the Business Cycle increase (decrease), the domestic currency tends to
depreciate (appreciate).
The price-to-earnings ratio of a stock market reflects the
price that the market is willing to pay for the earnings of Finance: Exchange rate is also affected by international
that market. flows of capital resulting from foreign direct investment
as well as from investments in stocks, bonds, or short-term
• The P/E ratio tends to increase (decrease) when instruments, including deposits.
earnings are expected to rise (fall).
• The P/E ratio tends to be high during the early stages • As domestic economic growth increases and new
of an economic recovery. industries are opened to foreign ownership, foreign
• The P/E ratio tends to be high when interest rates are direct investment increases and consequently,
low and fixed-rate investments (i.e. cash or bonds) domestic currency appreciates. Capital inflows
offer less attractive return. associated with foreign direct investment are
• The P/E ratio tends to be low when inflation is high considered to be more stable and less volatile
because investors assign lower value to reported compared to capital inflows associated with
earnings during inflationary periods. Hence, it is not investments in stocks and bonds.
appropriate to compare current P/E with past • As domestic interest rates increase, investments in
average P/E without controlling for the difference in domestic bonds, short-term instruments, or deposits
inflation rates. increase
capital inflows increase
domestic
currency appreciates.
Molodovsky Effect: P/Es of cyclical companies tend to • However, domestic currency may depreciate rather
be high at the bottom of a business cycle (i.e. economic than appreciate when investors expect economic
downturns) due to expectations of rise in future earnings slowdown due to higher interest rates.
when the economy recovers and tend to be low at the
top of a business cycle. 4.6.9) Approaches to Forecasting Exchange Rates

4.6.6.3 Emerging Market Equities There are four broad approaches to forecasting
exchange rates.
• Ex-post equity risk premiums for emerging markets,
1) Purchasing Power Parity (PPP): According to PPP,
on average, tend to be higher and more volatile
differences in inflation between two countries should
than those in developed markets.
be reflected in the changes in the exchange rate
• Ex-post, emerging market equity risk premiums in U.S. between them. That is, the currency of a country with
dollar terms tend to have positive correlation with relatively higher (lower) inflation tends to depreciate
business cycles in developed countries. (appreciate) against the other currency.

Transmission channels for G-7 macroeconomic For example, suppose that prices in Country A are
fluctuations to developing economies include trade (the expected to increase by 4% over the next year while
higher the growth in G-7 economies, the greater the prices in Country B are expected to rise by only 2%.
demand for the goods produced by emerging countries The inflation differential between the two countries is:
i.e. natural resources), finance, and direct sectoral
linkages. 4% – 2% = 2%

4.6.7) Real Estate

• This implies that increase in prices in Country A is
Systematic Determinants of Real estate returns include: greater than that of Country B. The PPP approach
forecasts that Country A’s currency will have to
• Growth in consumption depreciate by approximately 2% to keep prices
• Real interest rates (that reflect construction financing between countries relatively equal.
costs and the costs of mortgage financing): • If current exchange rate is 0.90 units of Currency A
Generally, lower interest rates imply lower per unit of Currency B, then under the PPP
capitalization rates and consequently, net positive approach, an exchange rate is forecasted to be =
return for real estate valuation. (1 + 2%) × (0.90 A per B) = 0.918 units of Currency A
• Term structure of interest rates per 1 unit of Currency B.
• Unexpected inflation
PPP is more useful to forecast direction of exchange
rates in the long-run (≥ 5 years). It is not useful in the short
or even medium run (up to 3 years).
Practice: Example 34,
Volume 3, Reading 14.
Reading 14 Capital Market Expectations FinQuiz.com

2) Relative Economic Strength: According to relative When an economy grows rapidly but domestic
economic strength forecasting approach, strong savings remain constant
capital investments
economic environment and favorable investment (representing demand for savings) > supply of
climate attract investments from foreign investors (i.e. domestic savings
the investment must be financed
investment flows) which in turn increases demand for from foreign savings i.e. from capital inflows from
the domestic currency and consequently, domestic abroad or through increase in imports; in other words,
currency appreciates in value. current account deficit (imports > exports) is needed.
And in order to increase imports or to attract and
• In addition, when domestic country has higher short- keep the capital inflows needed to fund savings
term deposit rates (reflecting higher yield on deficit, the domestic currency must appreciate in
investments)
demand for domestic currency value (either as a result of higher interest rates or
increases and consequently, domestic currency through strong economic growth).
appreciates in value.
• When domestic interest rates are low, it may induce • Eventually, as the currency strengthens and
investors to avoid investing in a particular country or domestic investments fall
current account deficit
even borrow that currency at low interest rates to widens
and the domestic currency may start to
fund other investments (known as carry-trade). decline, leading to current account surplus.

Unlike PPP approach, the relative economic strength NOTE:

approach does not predict about the level of exchange
rates; rather, it only helps to determine whether a Current account deficit of a country = Government
currency is going to appreciate or depreciate. This deficit + Private sector deficit.
approach can be used in conjunction with PPP
approach to develop a more complete forecast.
Practice: Example 36,
3) Capital Flows: The capital flows forecasting approach
Volume 3, Reading 14.
is based on long-term capital flows i.e. equity
investments and foreign direct investment (FDI).
According to this approach, the greater the capital
inflows, the greater the demand for currency, and 4.6.10) Government Intervention
consequently, the stronger the currency.
It is difficult for governments to control exchange rates
via market intervention alone because of the following
• When short-term rates are lower
economic growth three factors:
increases
stock markets perform well
long-term
investments become more attractive
demand for 1) The total foreign exchange reserves of major central
currency increases and consequently, currency banks combined is small compared to the total value
appreciates. of foreign exchange trading (>US$1 trillion daily).
2) Exchange rates depend on various fundamental
Hence, central banks face a dilemma; to strengthen factors besides government authorities.
depreciating currency, interest rates are required to 3) It is difficult to control exchange rates without
increase, but, higher interest rates may slow down the imposing capital controls.
economy, reducing the effectiveness of monetary
policy.
Practice: End of Chapter Practice
4) Savings-Investment Imbalances: The savings-
Problems for Reading 14 & FinQuiz
investment imbalances forecasting approach is
Item-set ID# 19084 &12513.
based on imbalance between domestic savings and
investments. This approach is useful to determine
causes of long-term deviation of currencies from their
equilibrium values. According to this approach,