1. Portfolio Management Unit – III Session No. 22 Topic: Economic Analysis Unit – III Session No. 22 Topic: Economic Analysis

2. Session Plan Recap the previous session International Interactions Economic Forecasting Economic Information in Forecasting Asset Class Returns Summarizing and Q & A

3. International Interactions The dependence of any particular country on international interactions is a function of its relative size and its degree of specialization. Large countries with diverse economies, such as the United States, tend to be less influenced by developments elsewhere than small countries, such as Chile, whose production depends significantly on a few commodities like copper. Increasing globalization of trade, capital flows, and direct investment means that practically all countries are increasingly affected by international interactions. Economic Analysis

4. International Interactions - Elements Macroeconomic Linkages Countries’ economies are directly affected by changes in the foreign demand for their exports. The other international linkages (other than trade) at work, such as those resulting from cross-border direct business investment Interest/Exchange rate linkages One of the linkages of most concern to investors involves interest rates and exchange rates. Sometimes, short-term interest rates are affected by developments in other countries because one central bank pursues a formal or informal exchange rate link with another currency. Emerging markets There are some special considerations in setting capital market expectations for emerging countries. Economic Analysis

5. Economic Forecasting Practical basics of macroeconomics for the investment analyst with many real- world illustrations which indicate some of the disciplines that the analyst can apply to economic forecasting. Often, analysts consider the implications of a variety of approaches, which will often raise questions that lead to productive analysis and insight. Approaches: Econometric models, the most formal and mathematical approach to economic forecasting. Leading indicators: variables that have been found to lead (precede) turns in the economy. Checklists, requiring the subjective integration of the answers to a set of relevant questions. Economic Analysis

6. Economic Forecasting Approaches: 1. Econometric Modeling Econometrics is the application of quantitative modeling and analysis grounded in economic theory to the analysis of economic data. Whereas generic data analysis can involve variables of all descriptions (possibly including economic, security characteristic, demographic, and statistical variables), econometric analysis focuses on economic variables, using economic theory to model their relationships. A very simple model is presented in the following series of equations: 1. GDP growth = function of (Consumer spending growth and Investment growth) 2. Consumer spending growth = function of (Consumer income growth lagged one period and Interest rate*) 3. Investment growth = function of (GDP growth lagged one period and Interest rate*) 4. Consumer income growth lagged one period = Consumer spending growth lagged one period Economic Analysis

7. Economic Forecasting Approaches: 2. Economic Indicators Economic indicators are economic statistics provided by government and established private organizations that contain information on an economy’s recent past activity or its current or future position in the business cycle. Lagging economic indicators and coincident indicators are indicators of recent past and current economic activity, respectively. A leading economic indicator (LEI) is a variable that varies with the business cycle but at a fairly consistent time interval before a turn in the business cycle. Economic Analysis

8. Economic Forecasting Approaches: 3. Checklist Approach Formally or informally, many forecasters consider a whole range of economic data to assess the future position of the economy. Checklist assessments are straightforward but time-consuming because they require looking at the widest possible range of data. The data may then be extrapolated into forecasts via objective statistical methods, such as time-series analysis, or via more subjective or judgmental means. An analyst may then assess whether the measures are in an equilibrium state or nearer to an extreme reading. Economic Analysis

9. Economic Information in Forecasting Asset Class Returns Cash and Equivalents Nominal Default-Free Bonds Defaultable Debt Emerging Market Bonds Inflation-Indexed Bonds Common Shares Real Estate Currencies Economic Analysis

10. Economic Information in Forecasting Asset Class Returns 1.Cash and Equivalents Cash managers make money through selection of the maturity of the paper in their portfolio or, if permitted by investment policy, by taking credit risk. Longer maturities and lower credit ratings reward the extra risk with higher expected returns. Managers lengthen or shorten maturities according to their expectations of where interest rates will go next. Normally, longer-maturity paper will pay a higher interest rate than shorter- maturity paper. Economic Analysis

11. 2. Nominal Default-Free Bonds Nominal default-free bonds are conventional bonds that have no (or minimal) default risk. Conventional government bonds of developed countries are the best example. Thus, our focus is on the government yield curve. 3. Defaultable Debt Defaultable debt is debt with some meaningful amount of credit risk —in particular, most corporate debt. For corporate debt, such as certificates of deposit and bonds, the spread over Treasuries represents at least in part the market’s perception of default risk. Economic Analysis

12. 4. Emerging Market Bonds Emerging market debt refers here to the sovereign debt (Govt issue for Foreign Currency) of non-developed countries. So far, we have considered only government issues and regarded them as virtually risk-free from a credit point of view. 5. Inflation-Indexed Bonds Many governments now issue bonds linked to inflation, so in principle, we can directly observe the market’s forecast of inflation by comparing the yield of these indexed bonds with the yield on similarly dated conventional bonds. Economic Analysis

13. 6. Common Shares To relate economic analysis to common equity valuation, it is useful to think of economic factors, first, in the way that they affect company earnings and, second, in the way that they affect interest rates, bond yields, and liquidity. 7. Real Estate To identify growth in consumption, real interest rates, the term structure of interest rates, and unexpected inflation as systematic determinants of real estate returns. Interest rates are linked with a number of factors that affect the supply and demand for real estate, such as construction financing costs and the costs of mortgage financing. Economic Analysis

14. 8. Currencies The exchange rate between two countries reflects the balance of buyers and sellers. One major reason for buying and selling foreign currencies is to facilitate trade in goods and services (exports and imports). If a country begins to import more, the currency will tend to depreciate (all else being equal). Hence, considerable attention is usually paid to determining a competitive exchange rate at which the trade balance—or, more broadly, the current account balance (which includes services and transfers)—is zero. Economic Analysis