Chapter 20 Global Economic Activity and Industry Analysis PDF
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2021
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This is a chapter on Global Economic Activity and Industry Analysis, covering topics such as top-down analysis, real GDP, business cycles, economic indicators, and the impact on investments. The analysis will help investors understand macroeconomic trends in various industries.
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Chapter 20 Global Economic Activity and Industry Analysis Copyright © 2021 McGraw-Hill Education. All rights reserved Global Economic Activity and Industry Analysis, I. “Blessed are the young, for they will inherit the national debt.”...
Chapter 20 Global Economic Activity and Industry Analysis Copyright © 2021 McGraw-Hill Education. All rights reserved Global Economic Activity and Industry Analysis, I. “Blessed are the young, for they will inherit the national debt.” –President Herbert Hoover Learning Objectives If you want the supply of your investment services to be in high demand, you should: 1. Understand the process of top-down analysis. 2. Be able to measure the level of economic activity—both globally and domestically. 3. Understand the relation of monetary and fiscal policies to economic activity. 4. Be able to identify industry sensitivity to business cycles. Global Economic Activity and Industry Analysis, II. Our goal in this chapter is to answer some general questions about economic activity. For example: What is the business cycle? How is economic activity measured? What is monetary and fiscal policy? How does economic activity impact sectors of the economy and the firms in these sectors? Answering these questions might help us anticipate economic movements. These predictions, in turn, might be valuable for deciding which investments to choose for a particular time period. Top Down Analysis, I. Some money managers use a “bottoms-up” approach to select securities. This approach does not use: perceived economic cycles industry specific information. The more common style is called “top-down” analysis. Money managers take a “big picture” perspective of the global economy. With the big picture in view, the manager then filters and sorts potential investments into smaller and smaller groups. This process is like a funnel: All possible investments go in at the top. Based on economic, industry, and company analyses, the money manager identifies the best potential investments. Top Down Analysis, II. Global Macroeconomic Activity, I. An important measure of economic health is gross domestic product (GDP). GDP is the market value of goods and services produced over a time period. GDP is an indicator, or measure, of the standard of living for people in a country. GDP is usually reported on a nominal basis. Nominal GDP reflects the dollar value of output in terms of the current year. Many economists prefer to focus on real GDP. Real GDP is nominal GDP adjusted for inflation. Using Real GDP makes it easier to compare standard of living across time periods. Global Macroeconomic Activity, II. Why do analysts care about real GDP? Suppose a country has nominal GDP increase from $1.29 trillion to $1.41 trillion in a year. This increase is 9.3%. If the country is experiencing high inflation, then the real economic growth is less. For example, if inflation were 7.1 percent during the year, then the real growth rate of the economy is closer to 2.2 percent (i.e., 9.3 percent − 7.1 percent). The Lesson: If investors use expected growth rates to decide on country investment levels, real GDP is a much better growth measure. What is the relationship between GDP and market values? They seem to be significantly correlated. Countries with the highest GDP also have the highest equity market valuations. The correlation value is.97—almost perfectly positive. Another Lesson: Investors wanting to allocate capital across countries should consider using GDP growth in their decisions. GDP versus Market Capitalization (15 leading economies in the world, as of early-2019) Business Cycles When estimating GDP growth, investors need to be aware of the business cycle. A nation’s GDP levels go through periods of ups and downs. In a national economy, this up and down movement is called the business cycle. The next slide has a simple picture of this cycle. The four stages of the cycle include peak, contraction, trough, and expansion. The figure suggests that the business cycle follows a rather smooth pattern, but reality is not so simple. Phases of the Business Cycle U.S. Real GDP, 1959—2018 (Where are the cycles?) U.S. Real GDP Growth (The cycles are in GDP growth) Sector Performance Across the Business Cycle Making Cyclical and Defensive Investment Decisions: Where will the Business Cycle go? Industries (and companies) have different sensitivities to the business cycle. Analysts often refer to cyclical or defensive industries or companies. Cyclical Sectors have above-average sensitivity to business cycles. Cyclical sectors are those that perform relatively better in a climate of strong growth. Examples: industrials and information technology Defensive sectors have below-average sensitivity to business cycles. Defensive sectors are those that perform relatively better in a climate of weak growth. Examples: health care and consumer staples Economic Indicators, I. Astute investors must be able to identify the economic indicators that help them make accurate forecasts of future economic conditions. Most economists rely on a group of leading economic indicators for this information. There are two other groups of indicators used to gauge economic activity: lagging indicators and coincident (i.e., simultaneous) indicators. The next slide contains a list of the major economic indicators within each of these three groups. Leading, Coincident, and Lagging Economic Indicators Economic Indicators, II. You might be surprised by item seven in the list of leading economic indicators: stock prices, 500 common stocks. Investors attempt to use economic information to help decide when and where to invest. One of the most accurate indicators, however, is the stock market itself. This accuracy is consistent with the general thought that the stock market does not reflect current conditions. Rather, the stock market is typically looking about six months ahead. So, we seem to have a “chicken and the egg” investing scenario. Because the current stock market level generally provides an idea of overall future economic health, trying to invest ahead of the market is quite a difficult task—even for the best investors. The Effects of Exchange Rates on Global Investments, I. Suppose we have $10,000 to buy shares of a company listed on the Deutsche Borse, the German stock exchange. We need Euros to make this investment. At the beginning of the year the exchange rate is $1.29/€. The shares increase in value by 10 percent during the year. At the end of the year, we sell the shares and convert the euros into dollars at a rate of $1.18/€. What is our net dollar return? The asset itself had a positive return. But, what about the impact of the exchange rate? As with any asset, we want to invest in currencies that are appreciating. The Effects of Exchange Rates on Global Investments, II. We held euros: Did they appreciate or depreciate relative to $US? At the beginning of the year, one euro could be converted into $1.29. At the end of the year, one euro could be converted into only $1.18. Thus, one euro is worth less in terms of U.S. dollars at the end of the year. This fact means that the euro has depreciated relative to the U.S. dollar. The euro depreciation means that the net return to the U.S. investor will not be ten percent. The asset return is reduced by the depreciation of the euro. The Effects of Exchange Rates on Global Investments, III. Let’s calculate the exact return. Step 1: Convert the U.S. dollars into euros at the beginning of the year. It takes $1.29 to “buy” one euro. Thus, with $10,000 we can purchase $10,000/ ($1.29/€) = 7,751.94€ worth of shares. Step 2: Calculate the ending value of the shares. The 7,751.94€ investment increased in value by 10 percent The ending value is 7,751.94€ × (1.10) = 8,527.13€ when we sell the shares. Step 3: Convert the euros back into dollars. At the end of the year, one euro can be converted into $1.18. Thus, 8,527.13€ × ($1.18/€) = $10,062.02. Step 4: Calculate the dollar-denominated return. The investment of $10,000 grew to $10,062.02. The return was.62 percent: ($10,062.02 / $10,000 ) ̵ 1. As we thought, the depreciation of the euro reduced the dollar-denominated return earned on the euro-denominated shares (which was 10 percent). Labor Market Indicators Economists divide the nonmilitary working-age population into three groups: 1. Employed 2. Unemployed (but seeking employment) 3. Unemployed and not seeking employment. The labor force is defined as all nonmilitary working-age people who are employed or unemployed (but seeking employment). The unemployment rate is the percentage of the labor force that is unemployed but seeking employment. The labor force participation rate equals the labor force divided by the nonmilitary working-age population. For example, in early 2019 in the U.S., the labor force was about 163 million people. This number represents a labor force participation rate of 63.1 percent, because the working-age population was about 258 million people. Of the labor force, about 3.9 percent, or 6.4 million, were unemployed. The other 258 − 163 = 95 million people were not seeking employment. The Consumer Price Index, I. The Consumer Price Index (CPI) is widely used to measure inflation. The CPI uses the average price of a fixed basket of goods and services. Inflation is the percentage change in the CPI from one period to the next. For example, suppose the CPI increases from 104.3 to 105.2 during the year The inflation rate is 0.9 percent for that year [=(105.2 / 104.3)/104.3]. Major parts of the CPI basket include housing, transportation, food, and beverages. Smaller parts include medical care, recreation, education, and apparel. Some economists focus on Core CPI, which excludes food and energy prices. The Consumer Price Index, II. On the next slide, you can see that there is a pronounced inverse relationship between inflation and Real GDP. This negative correlation means high inflation hurts real economic growth. This relation might be driven by the fact that high inflation leads to higher interest rates. Lenders will demand a higher interest rate to compensate for their loss in purchasing power. High interest rates tend to reduce the demand for loans—which, in turn, reduces economic growth. U.S. Real GDP Growth and CPI The Consumer Price Index, III. A common rule of thumb on Wall Street is that the inflation rate plus the market price-to-earnings (P/E) ratio should be about 20. While this is not an exact number and obviously varies through time, it does illustrate that inflation can affect stock prices. For example: Assume this Wall Street rule of thumb holds true. Suppose inflation is 4 percent; The market P/E ratio should be about 16. If inflation heats up and increases to 6 percent, then the P/E would likely fall, to about 14. For every dollar of earnings companies have, share prices would fall by about two dollars. Monetary Policy The money supply is important for the economy because it represents the “gas” for the economic “engine.” Giving the economy more gas (i.e., more money) makes it go faster. Giving it too much money, however, can result in overheating (i.e., high inflation). The goal of responsible policy makers should be to keep the money supply growing at the pace to keep the economy moving forward at the desired rate. On the next slide, you can see the importance of money supply for investors. There is a positive relationship between money supply growth and stock prices. Note: There are various ways to measure the amount of money, or money supply, in an economy. The most basic measure of money supply is called M1, which includes currency and checking deposits. A broader money supply measure, M2, is M1 plus time deposits, savings accounts, and money markets. U.S. M2 and S&P 500 Index, 1959—2018 The Federal Reserve: The Central Bank of the United States A central bank is a “banker’s bank”—provides loans and holds deposits (for banks). The Fed regulates many U.S. banks and also monitors and changes the money supply. The Federal Reserve is theoretically an independent federal governmental agency. Goals of the Fed: keep inflation in check, generate full employment, moderate the business cycle, and help achieve long-term economic growth. To achieve its goals, the Fed has primarily relied on its ability to change interest rates. The Fed has control over the discount rate, the interest rate the Fed charges its member banks on loans. The federal funds rate, which is the short-term rate at which banks lend to each other, generally changes with the discount rate. Changes in the federal funds rate can impact longer-term rates, like mortgage rates. All else equal, reducing the discount rate should stimulate demand for loans, which, in turn, spurs economic growth. Money Creation, I. The Fed has the ability to “pump” money directly into the financial system. To impact the money supply through the financial markets, the Fed conducts open market operations. To spur economic growth, the Fed buys Treasury bonds in the open market. Buying bonds puts money into the financial system The Fed pays dollars to the bond sellers. To put the brakes on the economy, the Fed sells Treasury bonds in the open market. Selling bonds takes money out of the financial system. The Fed received dollars from the bond buyers. Money Creation, II. Adding money to the financial system has a rippling effect, because of the fractional reserve banking system. In a fractional reserve banking system, banks must keep only a percentage (or fraction) of their deposits on reserve. This fraction is set by the Fed. Deposits that are not held on reserve can be loaned to borrowers. When borrowers make purchases, the sellers deposit the proceeds into a bank. A fraction of this deposit is set aside, and the remaining funds are lent again. As you can imagine, this process repeats over and over. How big is this rippling effect? With a 20 percent reserve requirement, total money supply from an initial $100 deposit can become $500 in total money supply. This potential expansion results from the money multiplier, which is calculated as 1 divided by the reserve requirement, 1/.20 = 5. (So, $100/.20 = $500 ). End user demand and bank lending standards, however, can prevent the money supply from reaching the amount predicted by the Fed. Fiscal Policy, I. The level of Federal tax rates and spending is referred to as fiscal policy. Potentially, fiscal policy has significant impacts on the overall economy. For example, if the government wanted to spur investment: it could reduce (or even eliminate) taxes on capital gains. Or, the federal tax code could allow for a faster depreciation of capital spending by businesses— which would also spur investment. Unlike citizens, the federal government is not forced to abide by, or even set, a restrictive budget. A “hot button” issue in recent years has been the fact that the federal government’s expenditures exceed tax revenues—the resulting shortfall is called the budget deficit. Over time, these budget deficits grow and increase the national debt, because excess spending must be paid for with borrowings. Fiscal Policy, II. As of early 2019, the national debt was over $22 trillion. In theory, the national debt finances government spending—part of GDP. Some believe that increased government spending actually grows economic activity. The downside of debt, however, is that it must be financed and repaid. In the long run, continued debt implies higher interest rates and increased taxes—slowing growth. To pay off debt, the federal government could simply print money. But, increasing the money supply too fast would spur inflation. The general consensus among pundits is that sustained budget deficits are detrimental for the long-run prosperity of an economy. For an investor, national debt can be a critical factor in choosing country investment allocations. Country Debt, 2010 Note: Spain’s recent debt level as a percent of GDP (64.4%) has been viewed as burdensome for economic growth. In early 2019, the U.S. Debt as a percent of GDP has increased to over 75%. Industry Analysis, Overview Economic information is helpful to investors when they are looking for areas of potential growth (or decline). While much of the discussion in previous sections focused on country-level issues, economic information is also useful for analyzing industries. For example, in an attempt to help spur the economy, the federal government passed a stimulus bill (through fiscal policy). Much of this new spending was supposed to go to capital improvements such as roads. As a result, many investors thought industrial firms would be big beneficiaries of this spending because new equipment would be required. To learn how to evaluate sectors and firms within an industry, we turn our focus to the general process of sector and industry analysis. There are Many Ways to Define a Sector A good starting point is the list of ten basic sectors used by Standard and Poor’s, the creator of the S&P 500 Index. On the next slide, you can see a list of the ten sectors, along with their early- 2019 index weights. Some sectors are quite small (such as telecommunications and utilities). Other sectors (such as financials and technology) are quite large. While these weights are not extremely volatile, they do change when some sectors do well relative to other sectors. In early 2007, financials comprised over 20 percent of the index weight. Financials were less than 15 percent of the index following the financial crisis and related Crash of 2008. Understanding the reasons behind these movements could give you an advantage, and maybe it gives you a way to weight your portfolio. Ten Sectors of the S&P, January 2019 Rotational Investing, I. Macroeconomic trends and government actions can favor some industries more than others. Unsophisticated investors might believe that if the S&P 500 return is positive, then the returns for all sectors must be positive. It is possible for some sectors within the S&P 500 to have a negative return over a given period even if the entire index has a positive return. As a result, active investors will decide to enter and exit industries. The process of moving investment dollars from one industry to another is often referred to as rotational investing because investors “rotate” dollars out of some industries Rotational Investing, II. The next slide provides a snapshot of performance differences. As of November 6, 2015, look at the data for the last week (the column labeled “Net (%) 7”) The consumer staples sector had lost about 1.53 percent of its value. The energy sector was up about 3.35 percent. Other time periods provide different stories about relative performance. For example, look at the data over the last year (the column labeled “Net (%) 360”): energy (−18.99%) consumer staples (3.41%) So, did investors sector rotate over that past year? S&P 500 Sector Returns (as of January 11, 2019) S&P 500 Heat Map, I. A “heat map” provides a visual snapshot of the market and sectors. The next slide shows a heat map that breaks down the S&P 500 into its major sectors. Within each sector, the heat map identifies the specific companies in the S&P 500. The size of each box represents relative market weights. Each box is color coded to identify whether the stock price for a particular company (and therefore industry) is up or down. The heat map changes throughout the trading day. S&P 500 Heat Map, II. Subsector (Industry) Differences, I. The eleven S&P sectors provide a good distinction across firms, but they are not without limitations. For example, do you think it would be good to group Starbucks and Ford Motor Company in the same business? Most investors would say that these two businesses are quite distinct. Starbucks is in retail, and Ford is in automobiles. Yet, S&P puts them both into the Consumer Discretionary sector. This example shows that sophisticated industry analysis often involves drilling down to uncover more detailed information. Subsector (Industry) Differences, II. Comparing subsectors is one way to gather information. These subsectors are often referred to as industry groups. One way to separate these groups is to use the Global Industry Classification System (or GICS). This system begins with the eleven S&P sectors, but it then subdivides them into 24 industry groups, 69 industries, and 158 sub industries. The GICS allows for a better comparison across firms. The Industry Life Cycle, I. There are other factors that lead investors to rotate sectors. One particularly relevant factor is the industry life cycle. The next slide shows that industries often follow this life cycle: Start-up Consolidation Maturity Decline Each industry is different and the stages can vary in length. By understanding an industry life cycle, investors might be able to identify which companies are poised for higher growth and which ones are likely to fade away. The Industry Life Cycle, II. Porter’s Five Forces Once investors have narrowed down the industries in which they are interested, they undertake some additional analysis. One particularly helpful approach is to use Porter’s Five Forces—named after strategy guru Michael Porter. The next slide illustrates the basic framework of this industry analysis technique. The goals of using the Five Forces: estimate then competitive level in an industry identify which firms might be best positioned for success Porter’s Five Forces Model of Competition Porter’s Five Forces: Details 1. Threat of new entrants: How easy is it for new firms to enter the market? High “barriers to entry” impact how likely a firm retains market share. Morningstar refers to these barriers to entry as a company’s “economic moat.” 2. Bargaining power of buyers: How hard is it for buyers to switch to another seller? The easier it is to switch, the more pricing pressure on the seller. This pressure affects how well a company can maintain its profit margin. 3. Bargaining power of suppliers: How easy is it for suppliers to raise prices? The easier it is for suppliers to raise prices, the hard it is for the company to control costs. This relative lack of control affects how well a company can maintain its profit margin. 4. Threat of substitute products: How easy is it for buyers to substitute another product? This area is similar to new entrants, but it goes a step further. For example, if beef prices increase significantly, a consumer could switch to chicken. Thus, firms face competition from products outside their specific industry. 5. Intensity of rivalry: The above factors help rate competitive intensity within the industry. Investors can then identify which industries (and companies) they think are most likely to retain (or gain) market share. Retaining (or gaining) market share is needed to grow profits (and increase the stock price). Useful Internet Sites www.economist.com (for data on current economic conditions) www.xe.com (exchange rates and a currency converter) www.usdebtclock.org (for a running tab of US federal government debt) finviz.com/map.ashx (to see the current heat map) www.msci.com/gics (learn more about GICS) jmdinvestments.blogspot.com (reference for the latest financial information) Chapter Review, I. Top-Down Analysis Global Macroeconomic Activity Real GDP Business Cycles Economic Indicators The Global Economy and Stock Return Correlations The Effects of Exchange Rates on Global Investments Monitoring Jobs and the Price Level Labor Market Indicators The Consumer Price Index Chapter Review, II. Monetary and Fiscal Policy Monetary Policy Fiscal Policy Industry Analysis Identifying Sectors Porter’s Five Forces
