Macro-Finance for Managers

1. Highlighting a Few Key Ideas and Issues Macro-Finance for Managers

2. MF Basics:M&M Isn’t Just an Abstract Idea • M&M: Equity ≈ Debt • For Corporate Finance: • Value of firm projects (revenue, costs) matters a lot more than small differences in costs of funds • Maybe liquidity issues at very high debt/equity ratios • For Macroeconomic Risks • Aggregate risk of projects (viability of revenue/income streams) more critical than whether equity financed or debt financed (compare 1920s v. 2000s) • Maybe liquidity issues at very high debt/equity or asset/equity ratios, especially in financial firms

3. MF Basics:Risk Drives Asset Prices • 1970s Thinking: Changes in expected earnings (numerator) is the driver • 2000 Thinking: 2000s: Changes in risk (denominator) is the driver • 2008 Crisis demonstrates the importance of the evaluation of risk to asset prices in the aggregate • Managerial Implications • Rapid shifts over time possible with variable denominator • P-E Ratios (or P/GDP) as Long Run Predictor • Very High P/E = current risk assessment overly optimistic • Very Low P/E = current risk assessment overly pessimistic

4. PE-Ratio and Long Term Risks:http://www.econ.yale.edu/~shiller/data.htm

5. MF Basics:Phillips Curve – A Tradeoff of More Money/Inflation for More Growth/Less Unemployment?

6. PE Ratios and SP500-GDP Ratio

7. MF Basics:The Fed, Markets, and Policy Limits • Fed & Rates: Taylor Rule Target Rate = 2 + 0.5*(Actual Inflation – Target Inflation) + 0.5*(Actual GDP – Potential GDP) • Phillips Curve concept built-in • Markets & Rates: Fisher Equation MarketRates = Real Rates + Expected Inflation • Real Rates influenced by economic growth (higher when growth higher) • Estimate of Real Rate: TIPS (See Bloomberg Rates) • Expected inflation influenced by Fed actions and velocity of money • Policy Limits: • No interest rate “knob” for Fed; influences with money creation • “Insurance” for system-wide panics

8. Nominal 10-Year Treasury Rate andInflation-Adjusted Rate (TIPS)

9. Fisher Equation (Market Events --inflation, real rates) Can Dominate Fed Targets 1970s: Impact of expected inflation 2008: Real rates collapse

10. MF Basics:Debt-Currency-Inflation All Linked • Even for Governments: • Expected PV of Liabilities = Expected PV of Assets • Liabilities = Money + Bonds • Assets = Discounted PV of Tax Revenue – Spending • When Markets Come to Evaluate M + B issuance much greater that PV(T-G) • Debt-Currency-Inflation Crisis • Germany 1920s, Mexico 1990s, Greece now, Italy? Spain?, Japan?, US? • Views/markets tend to switch all at once – “peso problem” so current market evaluation

11. Risks Ahead

12. Europe Now, Japan Around the Corner:http://www.econbrowser.com/archives/2012/08/how_long_can_ja.htmlhttp://media.chicagobooth.edu/mediasite/Viewer/?peid=f15d95d054e8442ab0cc1c60321383101d • Debt/GDP ratio must be viewed in relation to GDP growth potential, assets & savings, and likelihood of expenditure adjustments • Implications: Likelihood of low U.S. Treasuries through Japan issues

13. … U.S. Down the Line • Implication: U.S. Treasuries

14. Gauging Recession Risk Managerial Actions: Limit new projects; Put off new hires; De-leverage …

15. Single Best Market Indicator:Yield Curve Slope (10 Year – 3 Month Treasury Rates) • The Treasury Yield Curve: • Steep: High growth or inflation expected • Flat/Inverted: Low growth or inflation expected US Treasury Site "Living Yield Curve"

16. Yield Curve Slope and RecessionsFew False Positives or False Negatives Recession in Grey Few False Positives or False Negatives

17. Key Indicators of Asset Price Risk/Financial Market Stress Managerial Actions: Limit risk; increase liquidity; cash in fixed price assets; no new projects; secure longer term deals; … Remember: Individual market indicators often not very good at assessing turning points; looking for tell-tale indications

18. Composite Indexes from STL Fed and KC Fed

19. Interest Rate “Spreads”(LIBOR – TBill; Comm. Paper – Tbill)

20. LIBOR – Tbill(TED) Spread

21. Gauging the Top and Bottom:When Are Markets Way too Optimistic or Pessimistic(Shiller P-E Ratio)

22. Real Estate Asset Price Risk: Housing Price to Rental Ratio

23. Inflation Risk, Govt Liability Risk: Nominal Rate – Inflation Indexed Rate(Beware: Turning Points Not Easily Forecasted) Nominal 10- Nominal Rate Inflation Indexed Rate

24. 2008 Crash

25. Glance at Financial Crisis of 08:Debt, Debt, and More Debt

26. Mortgage Debt + A Whole Lot More

27. Role of Commercial Lending:Vegas City Center ($10B) Bond/Loan Financed

28. Why So Much Debt? • Cheap Credit • Public Sector Backing (Fannie, Freddie, Homeownership) • High Leverage (Assets/Equity) for Investment Banks (Bear, Lehman, Merrill …) + AIG • Banks Lending on 25 years of growth/repayment • Foreign Investment in US • NOTARIETY BUT TOO SMALL • Securitization (Collateralized Debt: CDOs) • Derivatives (Credit Default Swaps) • Market-to-Market Accounting

29. Who So Much Attention on Mortgages as Cause? • Mortgage-related securities marked-to-market daily • Immediately begin to reflect deteriorating conditions in 2007 • Commercial loans on bank books valued by banks at their PV of expected cash flow • Widespread writing down of these loans doesn’t begin until 2009, giving appearance that mortgage market problems causing these problems • Problems already developing coincidental with mortgage problems in 2007-08

30. Gold Price Index (Aug 2007 = 100)Inflation Risk or Other Risks?

31. Value of $ and Other Currencies:Falling While Gold Price Rising?