Macroeconomic Environment and Investment Decisions

1. Chapter9 The Macroeconomic Environment for Investment Decisions

2. LEARNING OBJECTIVES 1. Define gross domestic product and specify its components. 2. Identify the factors that affect a specific rate of interest. 3. Differentiate the discount rate, the federal funds rate, and the target federal funds rate. 4. Describe the tools of monetary policy and the mechanics of open market operations.

3. LEARNING OBJECTIVES 5. Contrast the different measures of the money supply. 6. Explain how monetary and fiscal policy and a federal government deficit may affect securities prices. 7. Determine which investments may be desirable in an inflationary environment.

4. Introduction -Investment decisions are affected by the various events occurring in the economic environment.-These events like unexpected changes in interest rates & recession cause the securities market to react.-The securities market reaction varies and cannot be expected.

5. The Economic Environment -The economic environment suggests that the economy does not follow regularly predictable patterns but have periods of expansion and contraction upon which all investment decisions are made.-These periods vary in length & severity that the circumstances affecting economy in one period may not affect it in subsequent periods.

6. Economic Environment Vs. Business Cycle -The economic environment was mistakenly referred to as “business cycle”.-However, economic environment and business cycle should not be interchangeably used.-As opposed to economic environment, the word “cycle” implies a regularly repeated pattern of events, such as the seasons of the year.

7. The Business Cycle

8. The Economic EnvironmentHistorical background • 1972 - 1999: only four periods of recession (started with Arab states of oil exports embargo as of Yom Kippur War in 1973- called first oil shock as price increased from $3 per barrel to nearly $12)

9. The Economic Environment Historical background -The energy crisis in 1979 upon the Iranian revolution and the resulted decline in the production of oil by 4% forcing prices to go up.-In 1980, production of oil in Iran stopped.After 1980, oil prices began a decline as production in Iran/Iraq returned to normal.

10. The Economic Environment • 1991 - 2001: ten years of unbroken economic growth. • Second quarter of 2002: economy sustained negative growth.- In July 2008, the price reached $147 a barrel. That large increase was a contributing factor to the economic downturn.

11. Recession • Recession (or contraction) A period of rising unemployment and declining national output. • Depression a particularly severe recession

12. Inflation • During most economic expansions • tendency for prices to increase (inflation) • The late 1990’s have been an exception to this pattern • modest inflation

13. The Economic Environment • During the 1930s, the failures of many commercial banks had an enormous impact on the economy and contributed to the Great Depression. During the late 1980s, the failure of many savings and loan associations and commercial banks created a financial crisis.

14. Economic Environment effect on stock prices • In many cases there is a strong relationship between stock prices and the aggregate economy. • The dramatic increase in the price of oil, the collapse of segments of the banking and financial system, and the severe decline in stock prices did inflict losses on investors during 2007 through 2009. • The next economic crisis may be very different.

15. Measures of Economic Activity • Economic activity is measured by aggregate indicators such as the level of production & national output. • Gross domestic product (GDP)-the most common measure of economic activity.-total dollar value of all final goods & services newly produced within a country’s boundaries by domestic factors of production.-Example: Cars made in the U.S. by Toyota are included in GDP, while IBM computers produced in Europe or Asia are not.

16. GDP is the summation of expenditures: • GDP = C + I + G + E • Expenditures are:(C): Personal consumption (I): Gross private domestic investment like investment in property &equipment (G):Government spending (E): Net exports (E) • Government taxation reduces the ability of individuals and firms to spend ,but it forces them to contribute to the nation’s GDP by tax revenues

17. GNP Vs GDP • (GNP) was replaced by GDP to emphasizes the country’s output of goods & services within its geographical boundaries. • GNP is the total value of all final goods and services newly produced by an economy including income generated abroad by U.S. firms & excluding income earned in the U.S. by foreign firms.

18. Measures of Consumer Confidence • Consumer confidence affects spending, which has an impact on corporate profits and levels of employment. • Measures of consumer confidence : -The Consumer Confidence Index (CCI) -The Consumer Sentiment Index (CSI) • Both measures provide indicators of consumer attitudes by focusing on (1) consumer perceptions of business conditions (2) consumer perceptions of their financial condition(3) consumer willingness to purchase durables

19. Forecasting Changes in the Economy • Changes in the indexes suggest changes in consumer optimism or pessimism • A decline in consumer confidence forecasts a reduction in the level of economic activity &vice versa.

20. From an investor’s perspective, the change in the economy resulting from a change in consumer confidence could lead to a shift in the individual’s portfolio. • A reduction in confidence that leads to economic contraction argues for movement out of growth companies into defensive stocks such as utilities or large firms (IBM or Merck) and debt instruments.

21. Leading Indicators • Leading indicators: the usefulness of the index of leading indicators for trading in stocks is limited, because stock prices are one of the leading indicators. • One indicator by itself is not an accurate forecaster. • It is impossible to tell when an indicator has changed. • The inability to forecast changes in stock prices is consistent with the efficient market hypothesis.

22. Forecasting Changes in the Economy

23. Measures of Inflation • Inflation is a general rise in prices and an important source of risk. • Inflation is measured by two indexes: • Consumer price index (CPI):measures the cost of a basket of goods and services over time. • The Consumer Price Index is separated into two indices: • -The all encompassing CPI -The “core” CPI which omits food and energy, whose prices tend to be more volatile.

24. An alternative measure of inflation to the CPI is the index of Personal Consumption Expenditures (PCE) • The PCE measures expenditures and the impact of changes in prices on consumer behavior. • Producer price index (PPI): measures the wholesale cost of goods over a period of time. • Changes in the Producer Price Index often forecast changes in the Consumer Price Index.

25. The rate of inflation is measured by changes in the index. • If the CPI rises from 100 to 105.6 during the year, the annual rate of inflation is 5.6 percent. • The impact of inflation on individuals depends on the extent to which they consume the particular goods whose prices are inflating. • Some analysts argue that the CPI overstates the true rate of inflation.

26. Deflation: • A general decline in prices, the real purchasing power of assets and income rises as the prices of goods and services decline. • Inflation has been a common occurrence, but deflation is rare. • While prices of specific goods and services may decline in response to lower demand or to lower costs of production, prices in general tend to be “sticky”

27. The Federal Reserve (the Fed) • The nation's central bank • Purpose: to control the supply of money in order to achieve • stable prices • full employment • economic growth • Easy monetary policy: Federal Reserve wants to increase the supply of money and credit to help expand the level of income and employment. • Tight monetary policy: desires to contract the supply of money and credit to help fight inflation

28. Determination of Interest Rates • Depend on the demand for and supply of loanable funds • Affected by the actions of the Fed • As interest rates decline, the quantity demanded of loanable funds increases & vice versa.

29. Increase in Supply of Funds Lowers Interest Rates

30. Decrease in Supply of Funds Increases Interest Rates

31. A Specific Interest Rate • Can be calculated asi = ir + Pi + Pd +Pl+ Pt.The current nominal interest rate (i) is the sum of the real risk-free rate (ir) and a series of risk premiums which are • expected inflation (Pi) • possibility of default(Pd) • Liquidity(Pl) • term to maturity (Pt)

32. The real risk-free rate is the return investors earn without bearing any risk in a noninflationary environment. • The inflation premium depends on expectations of future inflation. A greater anticipated rate argues for a higher rate of interest. • The default premium depends on investors’ expectations or the probability that the lender will not pay the interest and retire the principal.

33. The liquidity/marketability premium is related to the ease with which the asset may be converted into cash near its original cost. • Term to maturity: the term premium is associated with the time (or term to maturity) when the bond will be redeemed.

34. Impact of The Federal Reserve • The Fed affects interest rates through its impact on the ability of the banking system to lend. That is , it uses its power to change the money supply by using the tools of monetary policy.

35. The Tools of Monetary Policy • The reserve requirements of banks • The discount rate • open market operations.

36. The reserve requirement • The percentage set by the Federal Reserve that depository institutions must hold against deposit liabilities. • It is divided into required and excess reserve • If the reserve requirement is 10 percent and $100 cash is deposited, $10 must be held against the deposit (the required reserve) and $90 is available for lending (the excess reserves). • Changing commercial banks' reserves affects the capacity of banks to lend and thus affects the supply and cost of credit.

37. The discount rate • The rate of interest that the Federal Reserve charges banks for borrowing reserves. • By borrowing the necessary reserves, banks will not have to liquidate assets in order to obtain the funds to meet their reserve requirements which means maintaining the supply of money and credit. • changes in discount rate are only symbolic means to alter supply of money and credit.

38. Open market operations • The buying and selling of federal government securities. • When the Fed follows an expansionary policy, it purchases securities & the funds are deposited into commercial banks which will in return loan these funds & thus cause an increase in the supply of money and credit. • When the Fed follows a tight (contractionary) monetary policy ,it sells securities & the funds paid for flow out of banks which will drain the reserves from the banking system ,decrease its ability to lend & contracts the supply of money and credit. • Have a direct impact on interest rates. • The most important tool of monetary policy.

39. Monetary Expansion • To expand the money supply, the Fed buys government securities. • The purchases reduce interest rates • Paying for the securities puts reserves into the banking system

40. Monetary Contraction • To contract the money supply, the Fed sells government securities • The sales increase interest rates • Receiving payment for the securities removes reserves from the banking system

41. Impact on Stock Prices • Changes in monetary policy affect stock prices through:1-Changes in require return: Example: higher risk-free rate would lead to a higher required return and lower stock valuations.2-Changes in a firm’s earning capacity:Example: Reducing cost of credit may increase earnings resulting in higher dividends & more growth through retained earnings. • A change in interest rates is transferred to stock prices: higher interest rate reduces earnings & ability to pay dividends.

42. Fed Watching • Investors watch the Fed with the hope of anticipating the next change in monetary policy. • The Federal Open Market Committee (FOMC) -The most powerful component of the Fed. -has control over open market operations • The watching involves the meetings and the statements of FOMC and Board of Governance.

43. Money Supply • The Fed uses two definitions of money supply: • M-1 sum of cash, coin, and checking accounts (narrow or simple definition) • M-2 sum of cash, coin, checking accounts, plus savings accounts (broader definition) • shifting funds from savings accounts to checking accounts will -increase money supply under (M1) -not affect money supply under the broader definition (M2)

44. Money Supply • The monetary base:-An alternative measure of monetary policy -the sum of coins, paper money & bank reserves kept within a bank or at the Fed. • The growth in the money supply is related to economic growth and economic growth is related to stock prices. • Over time the money supply increases • The rate of increases varies • M-1 and M-2 do not always move together

46. Money Supply • Developing a successful investment strategy based on monetary policy is difficult as the market anticipate the changes. • To use changes in monetary policy as a guide for an investment strategy, • It is necessary to differentiate between -expected changes (the effects reflected in stocks’ prices)- unanticipated changes (which have an impact on stock prices)

47. Fiscal Policy • The federal government's management of: • taxation • Spending • debt management • Fiscal policy goals: -price stability-full employment- economic growth

48. Taxation • Taxation:-Corporate income taxes : reduce earnings , firms’ capacity to pay dividends and to retain earnings for growth. -Personal income taxes: reduce disposable income.

49. Deficit Spending • Government spending exceeds revenues • Sources of funds to finance the deficit • commercial banks • non-bank public • Federal Reserve

50. Surplus • Government revenues exceed Expenditures • Question of how to use any surplus