Capital Market Expectations

An increase in short-term interest rates may increase or decrease the value of the domestic currency.
Higher interest rates generally attract capital and increase the domestic currency value. At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy abd make it less attractive to invest there

U.S. TIPS are protected against increases in inflation. They would be needed the least when inflation is falling. During the initial recovery phase of the business cycle, the inflation is falling.

The analyst needs to understand the definition, construction, timeliness, and accuracy of any data used, including any biases. The time lag with which economic data are collected, processed, and disseminated can be an impediment to their use.
Furthermore, one or more official revisions to the initial values are common.
Definitions and calculation methods change too.
Suppliers of indices of economic and financial data periodically re-base these indices, meaning that the specific time period used as the base of the index is changed.

After the initial recovery period, confidence is up and the economy is gaining some momentum. This is the healthiest period of the cycle, in a sense, because economic growth can be robust without any signs of overheating or sharply higher inflation. Typically, there is increasing confidence, with consumers prepared to borrow and spend more as unemployment starts to fall. Concurrently, businesses build inventories and step up investment in the face of strong sales and increased capacity use. Higher operating levels allow many businesses to enjoy lower unit costs, so that profits rise rapidly.

A key question is how long it will take before inflation starts to become a problem. Short rates are moving up at this time as the central bank starts to withdraw the stimulus put in place during the recession. Longer bond yields are likely to be stable or rising slightly. Stocks are still trending up. This phase usually lasts at least a year and often several years if growth is not too strong and the output gap closes slowly.

A recession is conventionally defined as two successive quarterly declines in GDP. There is often a large inventory pullback and sometimes a large decline in business investment. Consumer spending on big-ticket items such as cars usually declines (although the US 2001 recession was an exception). Once the recession is confirmed, central banks ease monetary policy, but only cautiously at first. Recessions typically last six months to a year. Both consumer and business confidence decline. Profits drop sharply. In a severe recession, the financial system may be stressed by bad debts, making lenders extremely cautious. Often, recessions are punctuated by major bankruptcies, incidents of uncovered fraud, or a financial crisis. Unemployment can rise quickly, putting downward pressure on inflation.

There are four broad approaches to forecasting exchange rates, and most forecasters probably use a combination of them all:
Purchasing Power Parity
Relative Economic Strength
Capital Flows
Savings–Investment Imbalances

Quantitative models such as equilibrium models offer the prospect of providing a non-emotional, objective rationale for a forecast. The expectations-setting process nevertheless can give wide scope to applying judgment—in particular, economic and psychological insight—to improve forecasts. In forecasting, numbers, including those produced by elaborate quantitative models, must be evaluated.
Other investors who rely on judgment in setting capital market expectations may discipline the process by the use of devices such as checklists.

Nominal default-free bonds are conventional bonds that have no (or minimal) default risk.
For investors buying and selling long-term bonds over a shorter time period, the emphasis is on how bond yields will respond to developments in the business cycle and changes in short-term interest rates.
As bond investors look toward the long-term picture, they must carefully assess the future effects of inflation, which erodes the future purchasing power of the yields earned on their fixed-income investments.

The yield spread between the 10-year T-bond rate and the 3-month T-bill rate has been found internationally to be a predictor of future growth in output. The observed tendency is for the yield spread to narrow or become negative prior to recessions. Another way of saying the same thing is that the yield curve tends to flatten or become inverted prior to a recession.
Effects that may explain a declining yield spread include the following:
1) Future short-term rates are expected to fall, and/or
2) investors’ required premium for holding long-term bonds rather than short-term bonds has fallen.

Once interest rates are at zero, further monetary stimulus requires new types of measures.
First, the central bank can push cash (bank “reserves”) directly into the banking system.
A second possibility is to devalue the currency.
The third option is to promise to hold short-term interest rates low for an extended period.
The final option is for the central bank to buy assets directly from the private sector.

Countries with tighter monetary policy and stronger economic growth will see higher currency values. In fact, in the early 1980s, the U.S. had high real and nominal interest rates due to a tight monetary policym robust economy, and an increasing budget deficit. This resulted in a higher value of the dollar.

The illiquidity premium for an alternative investment should be positively related to the length of the investment’s lockup period or illiquidity horizon. How can the amount of the illiquidity premium be estimated? One estimation approach uses the investment’s multiperiod Sharpe ratio (MPSR), which is based on the investment’s multiperiod wealth in excess of the wealth generated by the risk-free investment (i.e., compounded return over compounded cash return).
There would be no incentive to invest in an illiquid alternative investment unless its MPSR—its risk-adjusted wealth—were at least as high as the MPSR of the market portfolio at the end of the lockup period.

The balance of payments (an accounting of all cash flows between residents and nonresidents of a country) consists of:
the current account, dominated by the trade balance (reflecting exports and imports), and
the financial account, consisting of portfolio flows (from security purchases and sales—e.g., bonds and equities) and foreign direct investment (FDI) by companies (e.g., Toyota Motor Corporation building an automobile assembly plant in the United States), as well as flows such as borrowing from and deposits with foreign banks.
The sum of the current account and the financial account, or the overall trade balance, should be zero.

Grinold–Kroner model, which is based on elaborating the expression for the expected single-period return on a share, is
E(Re)≈D/P−ΔS+i+g+ΔPE
where
E(Re) = the expected rate of return on equity
D/P = the expected dividend yield
ΔS = the expected percent change in number of shares outstanding
i = the expected inflation rate
g = the expected real total earnings growth rate (not identical to the EPS growth rate in general, with changes in shares outstanding)
ΔPE = the per period percent change in the P/E multiple
The term ΔS is negative in the case of net positive share repurchases, so −ΔS is a positive repurchase yield in such cases.
The Grinold–Kroner model can be used not only in expectations setting, but also as a tool to analyze the sources of historical returns.

At this stage of the cycle, the output gap has closed and the economy is in danger of overheating. Confidence is high; unemployment is low. The economy may grow rapidly. Inflation starts to pick up, with wages accelerating as shortages of labor develop.
Capital market effects: Typically, interest rates are rising as the monetary authorities become restrictive. Any heavy borrowing puts pressure on the credit markets. Central banks may aim for a “soft landing,” meaning a period of slower growth to cool the economy but not a major downturn. Bond markets (long-term interest rates) anxiously watch this behavior, and bond yields will usually be rising as a result of changed expectations. Stock markets will often rise but may be nervous too, depending on the strength of the boom. Nervous investors mean that equities are volatile.

For the purposes of setting capital market expectations, we need to focus business cycle analysis on four areas:
Consumer spending amounts to 60–70 percent of GDP in most large developed economies and is therefore typically the most important business cycle factor.
Business investment has a smaller weight in GDP than consumer spending but is more volatile.
Foreign trade is an important component in many smaller economies, for which trade is often 30–50 percent of GDP. However, for the large economies, such as the United States and Japan, foreign trade is typically only around 10–15 percent of GDP and correspondingly less important.

The analyst usually encounters at least two kinds of uncertainty in conducting an analysis: model uncertainty (uncertainty concerning whether a selected model is correct) and input uncertainty (uncertainty concerning whether the inputs are correct).
Input uncertainty and model uncertainty in particular often make it hard to confirm the existence of capital market anomalies (inefficiencies); some valuation model usually underlies the identification of an inefficiency. Behavioral finance (the theory that psychological variables affect and often distort individuals’ investment decision making) has offered explanations for many perceived capital market anomalies.

During the business cycle, the P/E ratio tends to be high and rising when earnings are expected to rise. For example, the P/E would be high in the early stages of an economic recovery, or when interest rates are low and the return on fixed-rate investments such as cash or bonds is less attractive. Conversely, P/Es are likely to be low and falling if the outlook for earnings worsens (e.g., in an economic slump).
P/E ratios vary over longer periods too. In general, they are lower for an economy stuck on a slower growth path.
High inflation rates tend to depress P/E ratios. Inflation can distort the economic meaning of reported earnings, leading investors to value a given amount of reported earnings less during inflationary periods, which tends to lower observed P/Es during those periods. Consequently, comparisons of current P/E with past average P/E that do not control for differences in inflation rates may be suspect.

A historical estimate should be considered a starting point for analysis. The analysis should include a discussion of what may be different from past average results going forward. If we do not see any such differences, we may want to project the historical estimates into the future (perhaps after making certain technical adjustments).
Changes in the technological, political, legal, and regulatory environments, as well as disruptions such as wars and other calamities, can alter risk–return relationships. Such shifts are known as changes in regime (the governing set of relationships) and give rise to the statistical problem of nonstationarity (meaning, informally, that different parts of a data series reflect different underlying statistical properties).
Researchers have concluded that the underlying mean returns on volatile asset classes such as equities are particularly difficult to estimate from historical data.

If fiscal and monetary policies are both tight, then the situation is unambiguous and the economy is certain to slow. Similarly, if both monetary policy and fiscal policy are expansionary, then the economy can be expected to grow.
Policy Mix and the Yield Curve:
Monetary&Fiscal/ Loose&Loose: Yield curve steep
Monetary&Fiscal/ Tight&Loose: Yield curve flat
Monetary&Fiscal/ Loose&Tight: Yield curve moderately steep
Monetary&Fiscal/ Tight&Tight: Yield curve inverted

The simplest way to analyze an economy’s aggregate trend growth is to split it into

growth from changes in employment (growth from labor inputs), and growth from changes in labor productivity.
For longer-term analysis, growth from changes in employment is broken down further into growth in the size of the potential labor force and growth in the actual labor force participation rate (e.g., more or fewer women or older people working; “growth” can be positive or negative).
Productivity increases come from investment in equipment or new machines (growth from capital inputs) and from growth in total factor productivity (TFP growth), known also as technical progress and resulting from increased efficiency in using capital inputs.

At this point, the economy is slowing, usually under the impact of rising interest rates. The economy is especially vulnerable at this juncture to a shock, which can turn a “soft landing” into a recession. Business confidence starts to waver. Despite the slowdown, inflation often continues to rise. The slowdown is exacerbated by the inventory correction as companies try to reduce their inventory levels. This phase may last just a few months, as in the United States in 2000, or it may last a year or more, as in the United States in 1989–1990 and 2009–2011.
Capital market effects: Short-term interest rates are high and rising at first but then may peak. Bonds top out at the first sign of a slowing economy and then rally sharply (yields fall). The yield curve often inverts. The stock market may fall, with interest-sensitive stocks such as utilities and financial services performing best.

If there is one single ratio that is most watched in all emerging market analysis, it is the ratio of the fiscal deficit to GDP. Most emerging countries have deficits and are engaged in a perpetual struggle to reduce them. Deficits are a major cause of slow growth and frequently a factor in serious crises. A persistent ratio above 4 percent is regarded with concern. The range of 2–4 percent is acceptable but still damaging. Countries with ratios of 2 percent or less are doing well. If the fiscal deficit is large for a sustained period, the government is likely to build up significant debt. For a developing country, the level of debt that would be considered too high is generally lower than for developed countries. Countries with a ratio of debt of more than about 70–80 percent of GDP are extremely vulnerable.

Annual growth rates of less than 4 percent generally mean that the country is catching up with the industrial countries slowly, if at all. It also means that, given some population growth, per capita income is growing very slowly or even falling, which is likely to bring political stresses.

Analysts watch several measures of debt burden. The ratio of foreign debt to GDP is one of the best measures. Above 50 percent is dangerous territory, while 25–50 percent is the ambiguous area. Another important ratio is debt to current account receipts. A reading above 200 percent for this ratio puts the country into the danger zone, while a reading below 100 percent does not.

During a recession, with falling inflation and interest rates, bonds generally post capital gains.
Inflation at or below expectations:
Yield levels maintained; market in equilibrium. [Neutral]
Inflation above expectations:
Bias toward higher yields due to a higher inflation premium. [Negative]
Deflation:
Purchasing power increasing. Bias toward steady to lower rates (may be offset by increased risk of potential defaults due to falling asset prices). [Positive]

According to elementary portfolio theory, the correlation between two assets is given by β1β2σ2M/σ1σ2

E(Re)=D0(1+g)/P0+g=D1/P0+g
where
D0 = the most recent annual dividend per share
g = the long-term growth rate in dividends, assumed equal to the long-term earnings growth rate
P0 = the current share price
The quantity g can be estimated most simply as the growth rate in nominal gross domestic product (nominal GDP).
A more advanced analysis can take account of any perceived differences between the expected growth of the overall economy and that of the constituent companies of the particular equity index that the analyst has chosen to represent equities. The analyst can use
Earnings growth rate = GDP growth rate + Excess corporate growth (for the index companies)

Low inflation can be benefitial for equities if there are prospects for economic growth free of central bank interference
Declining inflation ususally results in declining economic growth and asset pricies
The firms most affected are those that are highly leveraged because they are most sensetive to changing interest rates
Low inflation does not affect the return on cash instruments

Shrinkage estimation involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weights reflect the analyst’s relative belief in the estimates.
The term “shrinkage” refers to the approach’s ability to reduce the impact of extreme values in historical estimates. The procedure has been applied to covariances and mean returns.
A shrinkage estimator of the covariance matrix is a weighted average of the historical covariance matrix and another, alternative estimator of the covariance matrix, where the analyst places the larger weight on the covariance matrix he or she believes more strongly in.
A shrinkage estimator approach involves selecting an alternative estimator of the covariance matrix, called a target covariance matrix.

Statistical methods relevant to expectations setting include descriptive statistics (methods for effectively summarizing data to describe important aspects of a dataset) and inferential statistics (methods for making estimates or forecasts about a larger group from a smaller group actually observed).

The risk premium approach expresses the expected return on a risky asset as the sum of the risk-free rate of interest and one or more risk premiums that compensate investors for the risky asset’s exposure to sources of priced risk (risk for which investors demand compensation).
The risk premium approach (sometimes called the build-up approach) is most often applied to estimating the required return in equity and bond markets.

Data on business investment and spending on inventories reveal recent business activity. As already mentioned, both tend to be relatively volatile so that it is not uncommon for business investment to fall by 10–20 percent or more during a recession and to increase by a similar amount during strong economic upswings.

Economists and the markets have been skeptical about whether governments really can control exchange rates with market intervention alone because of three factors.
First, the total value of foreign exchange trading, in excess of US$1 trilliondaily, is large relative to the total foreign exchange reserves of the major central banks combined.
Second, many people believe that market prices are determined by fundamentals and that government authorities are just another player.
Third, experience with trying to control foreign exchange trends is not encouraging in the absence of capital controls.

Time-series estimators involve forecasting a variable on the basis of lagged values of the variable being forecast and often lagged values of other selected variables.
Time-series methods have been found useful in developing particularly short-term forecasts for financial and economic variables. Time-series methods have been notably applied to estimating near-term volatility, given persuasive evidence of variance clustering (particularly at high frequencies, such as daily and weekly) in a number of different markets.
Volatility clustering is the tendency for large (small) swings in prices to be followed by large (small) swings of random direction. Volatility clustering captures the idea that some markets represent periods of notably high or low volatility.

If the number of asset classes is n, the analyst will need to estimate (n2 − n)/2 distinct correlations (or the same number of distinct covariances)

Consumers can be counted upon as the largest source of aggregate economic growth in both developed and developing economies.
Overall consumer consumption is quite stable over the business cycle. Milton Friedman developed an explanation for this stability in his permanent income hypothesis. The permanent income hypothesis asserts that consumers’ spending behavior is largely determined by their long-run income expectations.
Thus, consumer trends are usually stable or even countercyclical over a business cycle. When incomes rise the most (during the cyclical expansion phase), spending increases less than income rises. When incomes fall as an economy’s growth slows or declines, consumption falls only a fraction and usually only for a relatively short period of time.