FIN 355 (23) - Business cycles, indicators, industries, inflation (module 7).pptx

FIN 355 Principles of Investments Business Cycles, Economic Indicators, Inflation Lecture Preview Big-Picture Motivation: Across the last century there have been repeated alternating cycles of high economic growth and recession. These business cycles will continue occurring in future decades. Hi...

FIN 355 Principles of Investments Business Cycles, Economic Indicators, Inflation Lecture Preview Big-Picture Motivation: Across the last century there have been repeated alternating cycles of high economic growth and recession. These business cycles will continue occurring in future decades. History shows that different types of investments are affected in different ways across the cycle. It is useful to consider the business cycle when making short- and mid-term investment decisions. Discussion Outline: • What are business cycles? How often do they occur? • Are there certain types of investments that are more or less attractive depending on where we are in the business cycle? • Introduce the logic for sector rotation investing around business cycles • Introduce economic indictors as a way for accessing where we currently are in the cycle • Inflation – What is it? How is it measured? How does it affect our approach to investments? You can see multi year cycles of up and downswings in a broad market index. The recessions are shown by the vertical gray bars. Can you see the downward swings in the stock market around the “dotcom crash”, the “financial crisis”, and covid years? Value can be modeled using discounted cash flow approaches. The S&P500 can be viewed as an aggregation of 500 firms’ DCFs. Firmvalue=¿ Firmvalue=¿ This graph shows the S&P 500 over 5 years. Note the aggregate revision in expected cash flows that must occur for a market-wide decrease in the stock index. 4 Business cycles Important Intuition: The economy goes through peaks and troughs every couple years. This is normal. These macrotrends are correlated with investors’ expectations for future cash flows and correlated with swings in other economic indicators. What is the benefit of recognizing these economic cycles? Is it possible to have a sense of where we are currently in the business cycle? • Different types of investments are more or less sensitive to certain parts of the cycle. • There are some investing approaches that tend to take better advantage of upswings and other approaches that better during downswings. • There are some industries that tend to do better during different parts of the cycle. • There are specific economic indicators that tend to move in advance, during, and after the economic cycle is changing. 5 Business cycle terminology The transition points across cycles are called peaks and troughs A peak is the transition from the end of an expansion to the start of a contraction A trough occurs at the bottom of a recession just as the economy enters a recovery 6 Betas provide some intuition for how a firm’s returns are likely to change across the business cycle What does a beta of 1.4 mean? What does a beta of 0.9 mean? • A beta of 1.4 means that on average the firm’s returns rise 1.4% when the market is up 1% and tend to fall 1.4% when the market is down 1%. • A beta of 0.9 means that on average the firm’s returns rise 0.9% when the market is up 1% and tend to fall 0.9% when the market is down 1%. Questions: Would you want to be invested in high beta stocks at the beginning of a contraction? Would you want to be invested in high beta stocks at the beginning of an expansion? What kinds of firms tend to have high versus low betas? What characteristics tend to be associated with higher betas? • • • • • Smaller firms Less-established/younger firms Firms with higher leverage High-tech firms Firms that sell mostly discretionary items What characteristics tend to be associated with lower betas: • • • • Larger firms Well-established/older firms Firms with less leverage Firms that sell items that are in demand in both good and bad economic years When would you expect most bankruptcies to occur? Default rates spike during the trough years of the business cycle. This has implications for bond investments. From our earlier lectures, bonds with BB or lower credit ratings are considered “speculative” whereas bonds with credit ratings above BB are considered “investment grade”. Bonds with lower credit ratings provide higher yields. Question: If you think the economy is starting a contraction, would you consider investing in speculativegrade bonds? Why or why not? 9 Bond prices move in the opposite direction as interest rate changes. When do interest rates tend to rise? When do they decrease? This has implications for short- and midterm investments in bonds. From Investopedia.com • “Central banks cut interest rates when the economy slows down in order to reinvigorate economic activity and growth. • Rates go up when the economy is hot. • The goal of cutting rates is to reduce the cost of borrowing so that people and companies are more willing to invest and spend. • Interest rate changes spill over to many facets of the economy, including mortgage rates and home sales, consumer credit and consumption, and stock market movements. • Interest rates and inflation have a direct relationship, which means that rates rise in order to keep inflation in check.” Question: Would it be a good idea to invest in bonds if you plan to hold the bonds for 1-2 years if you think interest rates will rise this year? Cyclical versus defensive Some industries tend to be cyclical where others are not. • Cyclical industries - these industries tend to have sales that are sensitive to contractions and expansions • Defensive/less cyclical industries - these industries tend to have sales that are less sensitive to contractions and expansions Question: When in the business cycle would it normally make the most sense to invest in a cyclical industry? Question: How do you know where we are in the cycle? • Some of the economic indicators tend to lead the cycle whereas others tend to lag. 11 Figure from the textbook showing the relative cyclicality of sales in grocery stores compared to jewelry stores. Looking at historical returns, different sectors tend to have different sensitivities to the business cycle. Example summaries of this data are shown in these figures. • The left figure is from the textbook. • The right figure is an example from a website (link in notes). 13 How would you define an industry? There are several common industry classification systems. Each has sector, industry, and subindustry groupings. • GICs – classification codes for industry groups (MSCI and S&P Dow Jones Indices) • NAICS – classification codes for industry groups (used by federal agencies, also used in Canada and Mexico) • SICs – classification codes for industry groups (replaced by NAICs) • Fama-French 48 – academic industry group classification based on SICs. 14 Leading Indicators • Leading indicators tend to rise and fall in advance of the economy • Examples: • Initial claims for unemployment insurance • Stock prices • Yield Curve 15 This is a table from the textbook. 22 example example websites websites with with information information on on economic economic indicators indicators •• https://www.conference-board.org https://www.conference-board.org •• http://newyorkfed.org/research/calendars/nationalecon_cal.html http://newyorkfed.org/research/calendars/nationalecon_cal.html 16 This figure is from an earlier edition of your textbook. This figure shows the how the indices of leading and coincident indicators change before and during recessions. In these figures the index levels are shown on the vertical axis. On the Conference Board website some of plots show the %change in the index level on the vertical. 17 Recent LEI CEI levels 18 The shape of the yield curve provides information about the economy 19 Yield curve over recent decades 20 This plot shows the 10-year treasury rate minus the 1-year treasury rate. An inverted yield curve appears when the shaded region dips below 0. Terminology and Intuition Inflation – The rate at which prices as a whole are changing (all else equal). – A sustained increase in the general level of prices for goods and services. – A reduction in purchasing power of a currency. Nominal Interest Rate – The rate at which money invested grows (includes the effect of inflation). Real Interest Rate – The rate at which the purchasing power of an investment increases (excludes the effect of inflation). Intuition: $100 today does not buy as many things as it would have 20 years ago. For example, the price of ice-cream cones, movie tickets, and school tuition have increased significantly over the last several decades. These are examples of inflation. Inflation can be thought of as the loss in purchasing power of a currency. Holding constant the quality of goods, inflation is measured by a percentage increase in the price of a representative basket of goods and services. In the U.S. the consumer price index (CPI) measures the change in purchasing power of dollars. CPI The CPI is calculated as the total price of a group of goods that a typical consumer would purchase (e.g. food, gasoline, clothing, etc.). The aggregate price of all the goods in the basket is divided by a number that makes the CPI index level number have a value around 300 in recent years. If the CPI index level goes up 3% over a year this means the average price of the goods in the basket have gone up 3% over that time. What is in the CPI “basket”? How is the data collected? “The CPI represents all goods and services purchased for consumption by the reference population... BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services).” - bls.gov This chart shows that the CPI level has increased in most years across time from 1971 - 2022. This version of the CPI measure includes all items used in US cities. The 1982-1984 CPI index level was set to 100. Recessions are shown by vertical shaded regions. Annual percentage change in U.S. CPI level: 1948 – Aug 2023 Recessions are shown by vertical shaded regions. Nominal rates include the effect of inflation. This means that “interest rates” were high in the years that inflation was high. The Fed “raises rates” at times to try to reduce inflation. This chart from the Atlanta Fed shows actual vs target core inflation targets. The core inflation measure has surpassed the target in recent years. The core CPI index measures the average price that urban consumers pay every month for the same basket of consumer goods excluding volatile items such as food and energy. There is a relation between the %change in money supply and the %change in CPI (inflation) but the relation is noisy because of other factors related to demand and supply changes as well as money that is part of the money supply but not in circulation. In recent years the Fed has argued that the recent increase in inflation has more to do with changes in demand and supply than direct changes in money supply. Many economists still view changes in the money supply as a large part of the issue but it is true that much of the temporary increases in money supply seem to be held as bank reserves rather than “chasing goods”. The US M2 money supply grew a lot in 2020 – 2021. To the extent that the new money represent additional funds “chasing the same goods” this results in inflation of prices for those goods. If the goods in the CPI basket cost $105 this year and only $100 last year, then inflation was 5% last year. Say you are working part-time and earn $20,000 in income this year. Your employer gives you a 10% raise each year and inflation is 5% per year. Are you 10% better off each year? (Similarly, if your alternative investment gives you a 10% return this year, are you 10% wealthier?) Rate of inflation Real value of $1.00 Nominal income (growth = 10%) $1.00 $20,000 Year CPI Level 0 100.00 1 105.00 5.0% $0.9524 $22,000 2 110.25 5.0% $0.9070 $24,200 2 common measures of inflation CPI (Consumer Price Index): Price index based on the price of basket of goods. Inflation is calculated from year-to-year as . PPI (Producer Price Index): Price index that measures average change in selling prices received by domestic producers of goods and services. Real and nominal interest rates A small milk shake costs you $1 today. If inflation is expected to be 5%, you can expect a small milk shake to cost you $1.05 next year. If you invest $100 (=100 shakes) today at a nominal rate of 8%, you will receive $108 (actual dollars you receive) in one year. Are the $108 real or nominal? What is the real rate of return? Real and nominal interest rates, continued... Remember that shake prices have increased over the year. Hence each dollar buys fewer milk shakes next year than today. With $108 next year, you could buy ($108/$1.05) = 102.86 shakes next year. Therefore in one year you will receive $102.86 real dollars. That is, after adjusting for the increase in general prices, your real return is only 2.86% -- not 8%. Formula relating real and nominal rates (Fisher equation) To calculate nominal or real rates you can use the Fisher equation: (1+ nominal rate) = (1 + real rate) (1 + inflation rate) Using the numbers from the milk shake example: 1+real rate = (1 + .08) / (1 + .05)  real rate = 2.86% ** Be sure to look at the example problems at the end of the slide set that show this formula in use. True/false concept checks 1. Nominal dollars refer to the amount of purchasing power. 2. The CPI index price level has generally remained at the 1984 level over the last 20 years. 3. Inflation is measured using simple year-to-year differences in the CPI. 4. All price changes are inflation. This chart shows that the CPI level has increased in most years across recent decades. This version of the CPI measure includes all items in US city average. The 1982-1984 CPI index level was set to 100. Recessions are shown by vertical shaded regions. How does inflation affect your investments and savings? There are (nominal) rates of return associated with each of these common investment items but the real impact on your wealth can only be calculated after you account for inflation: • Savings accounts • Equity investments • Bond investments Key Intuition: The purchasing power of your savings, equity investments, and bond investments will decrease over time if the inflation rate is larger than the nominal growth. Are there other types of investments that are less sensitive to inflation? • TIPs: Treasury inflation protected securities offer a real rate of return that accounts for inflation. Although these securities offer protection from the effects of inflation they don’t offer a lot of upside return. • Real estate • Property values tend to rise with inflation. • Some REITs have lease agreements that are updated to account for inflation and hence offer • higher cash flows over time if there is inflation. If you take out a mortgage with a fixed payment, over time in the presence of inflation your salary will likely increase and the relative size of your mortgage payment will decrease relative to the rest of your budget. In contrast, if you rent your monthly payments will likely increase with inflation. • Commodities (I.e., gold, oil, grains, etc.) • To the extent that commodity prices (and returns) are set on an ongoing basis by supply and • demand considerations, the prices of commodities increase with inflation. But if you are investing in commodities via futures contracts, the shape of the futures curve can make “rolling” the investment from short-term to long-term contracts expensive. • Resource equities (i.e., utilities, energy, food, etc.) • The demand for some items persists across all years. Are there other types of investments that are less sensitive to inflation? Key Intuition: Broadly speaking returns on essential “real assets” do better over times of high inflation than returns on other types of investments. You can think of “real assets” as “physical assets that have intrinsic worth due to their substance and properties.” For next time.. Review the concepts and terminology introduced in today’s lecture 40 Terminology You should be able to give a 1-2 sentence description of each of these terms. • • • • • • • • • SIC GICS NAICS Leading economic indicators Coincident indicators Business cycle Trough Peak Contraction • • • • • • Expansion Inverted yield curve Fisher Equation Nominal vs real rates Sector rotation Which investments are good during expansions? Contractions? Thank You Concept check – practice using the Fisher Equation If investors are to earn a 3% real interest rate, what nominal interest rate must they earn if the inflation rate is… a. 0%? b. 4%? c. 6%? Concept check – practice using the Fisher Equation If investors are to earn a 3% real interest rate, what nominal interest rate must they earn if the inflation rate is… a. 0%? b. 4%? c. 6%? (1+nominal rate) = (1+real rate) (1+inflation rate) a. 1.03 1.0 = 1.03 nominal rate = 3.00% b. 1.03 1.04 = 1.0712 nominal rate = 7.12% c. 1.031.06 = 1.0918 nominal rate = 9.18% Concept check – practice using the Fisher Equation I would like to take a large family vacation when my kids get older. I want to take the vacation five years from now. The kind of vacation I want to take would cost $10,000 today. How much will I need in year 5 to pay for this type of vacation? Pick the number closest to the correct answer. Assume that inflation will be 3% per year and that my savings account offers 2% return per year. A. $10,000 B. $11,040 C. $11,590 D. $12,760 Concept check – practice using the Fisher Equation I would like to take a large family vacation when my kids get older. I want to take the vacation five years from now. The kind of vacation I want to take would cost $10,000 today. How much will I need in year 5 to pay for this type of vacation? Pick the number closest to the correct answer. Assume that inflation will be 3% per year and that my savings account offers 2% return per year. A. $10,000 B. $11,040 C. $11,590 D. $12,760 Answer: C 10,000*(1.03)5 = $11,592.741 <- inflate the price with 3 years of inflation