Source: Captial Market Expectations, Part 1 : Framework and Macro Considerations - Christopher D. Piros
1. Fundamental law of investing is the uncertanity of the future
2. Capital market expectations - are expectations concerning the risk and return prospects of asset classes
3. A disclipined approach to setting expecatations will be rewarded
4. The ultimate objective is to develop a set of projections whith which to make informed investment decisions, specifically asset allocation decisions.
5. Asset allocation is the primary determinant of long-run portfolio performance
6. Good economic forecasts are
- unbiased, objective and well researched
- efficient, in the sense of minimizinf the size of forecast errors and
- internally consistent, bith cross-sectionlayy and intertermporally
7. Forecasts are subjects are subject to three kinds of uncertanity
8. Data may be subject to survivorship bias, in which only successful entities are included in the reporting
1. Model Uncertanity
2. Input Uncertanity
3. Parameter Uncertanity
9. Data that has undergone regime change suffers from different data definitions in the distinct part of the series. This gives rise to nonstationarity, in which the distinct parts have different variances and result in inaccurate models. When this happens analysts should only use the longest part of the time series relevant to present conditions.
10. Lack of linear correlation may not indicate lack of correlation; the relationship may be nonlinear.
11. Intertemporal consistency - consistency over various time horizons.
12. Cross sectional - consistency across asset classes
13. High frequency data improves the precision of smaple variances, covariances and correlations but not the precision of the sample mean
Psychological traps
- Anchoring - Analyst's tendency to put too much weight on the first set of information received
- Status Quo bias - reflects the tendency for forecasts to perpetuate recent observations - that is, to avoid making changes and preserve the status quo, and/or accept the default opinion.
- Confirmation bias - is the tendecny to seek and overweight evidence or information that confirms one's exisiting or preferred beliefs
- Overconfidence bias - is unwarrented confidence in one's own intutive reasoning, judement, knowledeg, and/or ability.
- Prudence bias - reflects the tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting.
- Availability bias - is the tendency to be overly influenced by events that have left a strong impression and/or for which it is easy to recall an example.
Economic and Market Analysis
Exogenous shocks to growth - Policy changes, new products and technologies, Geopolitics, Natural disasters, Natural resources/critical inputs and Financial crises
Financial Crises may be grouped into three types:
Type 1 - A permanent, one-time decline with resumption of trend rate after the initial shock
Type 2 - No presistent one-time decline but continuing at a lower rate
Type 3 - Both a permanent, one-time decline and continuation at a lower trend rate
Trend analysis is generally decomposed based in inputs to economic growth
- Labor input growth
- Labor productivity growth
Business Cycle Analysis
- It is useful to think
- Numerous variables can be used to monitor the business cycle. Among them are GDP growth, industrial production (IP), employment/unemployment, purchasing manager indexes, orders for durable goods, the output gap
- For the purpose of setting expectations for captial markets, we use five phases of the business cycle. The first four occur within overall expansion.
- Inital Recovery: Begins at the trough of the business cycle in which the economy picks up. Cyclical assets attract investors and perform well.
To identify IR -> Outgap large, Inflation decelarating
- Early Expansion: Economy gaining momentum. Profits typically rise rapidly, Demand for housing and consumer durables is strong.
- Late Expansion: Boom mentality prevails. Central bank may aim for a "soft landing" while fical balances improve. Cyclical assets may underperform while inflation hedges such as commmodities outperform
- Slowdown: The economy approaches an eventual peak. The stock market may fall, with interest-sensitive stocks such as utlities and "quality" stock with stable earnings performing best
- Contraction: Recessions are often punctuated by major bankruptcies, incidents of uncovered fraud, exposure of aggressive accounting practices, or a financial crises. Unemployment can rise quicly, imparing household financial positions.
Challenges predicting the next phase of the business cycle
- The phases of the business cycle vary in length and amplitude.
- It is not always easty to distinguish between cyclical forces and secular forces acting on the economy and the markets
- Although the connection between the real economy and captial market returns is strong, it is subject to substantial uncertanity
Analysis of Monetary and Fiscal Policy
- Central banks virtually always aim to moderate the cyclical behavior of growth and inflation, in both directions. Thus, monetary policy aims to be countercyclical.
- The impact of monetary policy, however, is famously subject to "long and variable lags", as well as substantial uncertanity
- Monetary policy is asymmetric; it being easier to stop an expansion than to end a severe contraction
- Expansionary policy is like "pushing" on a string, whereas restrictive policy is like "pulling" on a string
- Fiscal policy (govt spending and taxation) can also be used to counteract cyclical fluctations in the economy
- The effect of so-called automatic stabilizers should not be overlooked in setting expectations for the economy and the markets
- The Taylor rule, or some customized variant provides a good framework for analyzing the thrust and likely evolution of monetary policy, but the analyst must pay careful attention to situational signals from the central bank
- Fiscal policy is inherently political.
- Loose fiscal policy
The Shape of the Yield Ccrve and the Business Cycle
Negative Rates
- In theory, using negative nomical rates to stimulate an economy should work similarly to low but still positive rates. Businesses and customers are encourages to hold fewer deposits for transaction purposes; investors are encourages to seek higher expected return on other assets; consumers are encourages to save less and/or borrow more against future income; businesses are encouraged to invest in profitable projects; and banks are encourages to use their reserves in support of larger loan books. All of this is expected to stimulate economic growth
QE -
- Following the global financial crisis, central banks faced with this suitation pursured less convetional measures.
- One important measure of QE, central banks committed to large-scale, ongoing purchases of high quality domestic fixed-income securities. As a result of QE, central bank balance sheets and bank reserves grew significantly and soverreign bond yields fell. QE was pursued by (among others) the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England.
Inflation - Not good for bonds.
Deflation - generally falling prices
Macroeconomic Linkages
- 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 economices, tend to be less influenced by developments elsewhere than smaller economies
- Macroeconomic linkages bewtween countries are expressed through their respective current and captial accounts. Anything that affects one account must induce an equal and opposite change int the other account.
- A surplus on captial account is how a nation funds an excess of investment and government spending over domestic saving plus taxes.
Interest Rate/Exchange Rate Linkages
When exchange rate is allowed to float, the link between interest rates and exchange rate is primarily expectational. To equalize risk-adjusted expected returns across markets, interest rates must be generally be higher (lower) in a currency that is expected to depreciate (appreciate)
An investor cares about the real return in their own currency. In terms of non-domestic currency asset, what matters is the nominal return adn the change in exchange rate.
Although real rates around the world need not be equal, they are linked through the requirement that global savings must always equal global investment.
If a currency is linked to another without full credibility, then bond yields in the weaker currency are nearly always higher.
Progressive tax regimes imply that the effective tax rates on private sector is procyclical (i.e rising as the economy expand and falling as the economy contracts)