R16 capital market expectations

Use past data to forecast future outcomes – Example: use historical returns to predict future returns • Shrinkage Estimators involve taking weighted average of a historical estimate of a

Reading 16

Capital Market Expectations

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• Capital Market Expectations: investor’s expectations concerning

the risk and return prospects of asset classes

• Investor can decide how he defines assets classes

• Macro Expectations vs Micro Expectations

Major Sections in this Reading:

– Framework and Challenges

– Tools for Formulating Capital Market Expectations

– Economic Analysis

2 Organizing the Task: Framework and Challenges

1 Specify final set of expectations that are needed

2 Research the historical record

3 Specify required models and information requirement

4 Determine best sources for information needs

5 Interpret current investment environment

Step 1: Specify the final set of expectations that are needed, including the time horizon to which they apply

• Understand specific objectives of analysis

• Set boundaries  focus on what is relevant

• Write the questions which need to be answered

Step 2: Research Historical Trend

• Most forecasts have connection to the past

• Understand factors which drive returns

• Can collect data based on geographic region, assets classes, sub-asset

classes…

Step 3: Specify methods and/or models that will be used and their

information requirement

• Consider time-horizon when selecting appropriate model

• Long time horizon  DCF Model

Step 4: Determine the best sources for information needs

• Data quality, Cost, Frequency

Step 5: Interpret the current investment environment using the selected data and methods, applying experience and judgment

Step 6: Provide the set of expectations that are needed,

documenting conclusions

• Answer the questions which were formulated in Step 1

• Read Example 4

• Good forecasts are:

– Unbiased, objective and well researched

– Efficient  minimize forecast errors

– Internally consistent (Example 5)

Step 7: Monitor, feedback  improve forecasts

2.2 Challenges in Forecasting

• Limitations in Economic Data

– Definitions (GDP vs GNP, Example 6), construction, timeliness, accuracy,

2.2 Challenges in Forecasting (Cont…)

• The Limitations of Historical Estimates

– Changes in regime  non-stationarity

– You can use regression analysis to identify change in regime (Ex 9)

• Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

2.2 Challenges in Forecasting (Cont…)

• Biases in Analysts’ Methods

– Data Mining Bias

– Time-Period Bias: biases which are time period specific Ex: high small

cap returns from 1975 - 1983

• Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

2.2 Challenges in Forecasting (Cont…)

• Failure to Account for Conditioning Information

– Classic error: not recognizing that equity returns are conditional on the

economy Exhibit 2:

2.2 Challenges in Forecasting (Cont…)

• Misinterpretation of correlations Example 10 High correlation

between A and B could be because:

– A predicts B

– B predicts A

– C predicts A and B

2.2 Challenges in Forecasting (Cont…)

• Psychological Traps

– Anchoring Trap

– Status Quo Trap

– Confirming Evidence Trap

3 Tools For Formulating Capital Market Expectations

3.1 Formal Tools

– Statistical Methods

– Discounted Cash Flow Models

– Risk Premium Approach

3.2 Survey and Panel Methods

3.3 Judgment

Statistical Tools

• Historical Statistical Approach: Sample Estimators Use past data to

forecast future outcomes

– Example: use historical returns to predict future returns

• Shrinkage Estimators involve taking weighted average of a historical

estimate of a parameter and some other parameter estimate

– Example: covariance is 48 using one model and 80 using another

– Example 12

Global Equity Factor and Global Bonds Factor drive returns of all assets

Std dev 14% 4% Corr = 0.30

To derive asset covariance matrix we need to know how a market responds to factor movements

If Market A moves 110 points in response to 100 point move of global equities…

Factor sensitivity = 1.1

We can say Market A is a pure equity market

Factor Covariance

Discounted Cash Flow Applications

Equity Markets  Gordon Growth Model

Grinold-Kroner Model Do Examples 13 and 14

The Risk Premium Approach

• Sum of risk free rate and one or more risk premiums Examples 15, 16 and 17

• Equity Risk Premium

Financial Market Equilibrium Models

• These models assume that markets are efficient… fully integrated and in

equilibrium

• Example: International CAPM

1 Calculate risk of asset class assuming full integration

2 Calculate risk premium of asset class assuming complete segmentation (consider illiquidity premium)

3 Weighted average based

Example 18 covers several concepts A couple of refreshers:

Lock up period  higher expected return

Correlation between two assets:

3.2 Survey and Panel Methods

• Survey: ask group of experts for their expectations… use their responses in

coming up with CME

• If we have a panel of experts  Panel Method

• Example 20

3.3 Judgment

• Example 21

4 Economic Analysis

• Relationship between realized asset returns, expected returns

and economic activity

• This is a long session which covers:

– Business cycle and inventory cycle

– Economic growth trends

4.1 Business Cycle Analysis

• Inventory Cycle

• Business Cycle

• Inflation and Deflation in the Business Cycle

• Market Expectations and Business Cycle

• Factors Impacting Business Cycle

Inventory Cycle

• Measures fluctuations in inventories; lasts 2 – 4

years

• Caused by companies trying to keep inventories at

desired levels as expected level of sales changes

• In up phase businesses are confident about future

sales and increasing production

– Higher employment  boosts economy

• When sales don’t increase as expected business

cut back (inflection point)

• Takes a year or two to correct inventory levels

• Major indicator: inventory/sales ratio

Business Cycle

• (Real) GDP

• Output Gap

• Recession

Exhibit 15 Five Phases of the Business Cycle

Inflation and Deflation in the Business Cycle

• Inflation tends to rise in late phases of a business cycle

• Declines during recession and early stages of recovery

• Inflation and deflation have an impact on asset returns (Exhibit

18, next slide)

• Analysts should forecast inflation (Example 24)

Market Expectations and the Business Cycle

• Consumers

– Store sales data, consumption data

– Consumer income after tax

– Employment data

• Business

– Business investment, inventories

– US Example: Purchasing Managers Index (PMI)

• Foreign Trade

Business cycle analysis…

Analyst should try to predict central bank’s policy rate

This can be done using the Taylor Rule

If the inflation forecast is 4 percent and the forecast for GDP growth is 1

percent, what is the optimal short-term interest rate?

Fiscal Policy:

Manipulating budget deficit to influence economy

1 Focus on changes in budget deficit, not the actual level

2 Focus on deliberate changes in government fiscal policy

4.2 Economic Growth Trends

• Components of Economic Growth Trends

– Growth from changes in employment

– Growth from changes in labor productivity

• Capital

• Technology (Total Factor Productivity)

• Investment  Capital  Growth

– Singapore and China invested 30 – 40% of GDP

• Economic growth also influenced by government

policy

– Sound fiscal policy, minimal intervention, competition

4.3 Exogenous Shocks

• Events from outside the economic system that affect its course

• Shifts in government policies

– For example: limits on spending

• Oil Shocks

– Impacts consumer income and reduces spending

• Financial Crises

– Growth rate down because of reduced bank lending

– Reduced investor confidence

4.4 International Interactions

• Dependence of a particular economy on international

interaction depends on size and degree of specialization

• Macroeconomic Linkages

– Economies impacted by changes in foreign demand for their exports

– Weakness in the U.S has a major impact on many countries

– Integration is increasing, especially between developed countries

– Correlation is not perfect

Interest Rate/Exchange Rate Linkages

• Some economies linked through fixed/pegged

exchange rates

– Example: GCC country currencies pegged to the USD

– Interest rate differential depends on confidence in the peg

• With floating exchange rate, currency with higher real

exchange rate will appreciate

• If we assume real interest rate differential is 0 

predict exchange rate based on interest rate parity

relationships

Emerging Markets

• High risk, high return

• High investment, high debt

• Important questions to ask when investing in emerging

markets

– Monetary and fiscal policy

– Economic growth prospects

– Currency competitive? External accounts?

– External debt?

– Liquidity

– Political situation supportive of necessary economic policies

Econometric Modeling

Quantitative methods + economic theory  economic forecasts

GDP Growth = f(Consumer Spending Growth, investment growth)

• Model complexity depends on number of variables

• Requires good data

• Useful for simulating effect of changes in specific variables

• Require judgment

• Poor at forecasting recessions

Economic Indicators

Early signs of probable events to come

Checklist Approach

Consider range of economic data to assess future position of the economy

Exhibit 25 Advantages and Disadvantages of Three Approaches

Example 30.

Analyst Forecasts

4.6 Using Economic Information in Forecasting Asset Class Returns

• Cash and equivalents

– Make money through selection of maturity and by taking credit risk

– If interest rates likely to fall go with higher maturity

Example 31

Nominal Default-Free Bonds

Total yield = real yield + inflation

Investors determine whether bonds are cheap or expensive

Say 10-year bonds yield 5% and inflation = 2%

Investor expects inflation to be 0.5%

Should he invest?

Investing in long term bonds over a short period…

News of stronger economic growth  higher yields  low prices

Defaultable Debt

Spread over treasuries depends on: default risk of issuer and state of the economy

Emerging Market Bonds

Sovereign debt of non-developed countries

Inflation Indexed (Real) Bonds

Economic growth rising  Yields rise

Inflation expectations rise  Yields fall

Investor demand rises  Yields fall

Common Shares

1 Economic factors impacting earnings

Also take a close look at Example 33/Exhibit 28

2 P/E Ratio and the Business Cycle

High in early stages of economic recovery

High inflation rates depress P/E ratios

3 Emerging Market Equities

Equity risk premiums are higher and more volatile than developed market equities

Real Estate

Example 34: Modifying Historical Capital Market Expectations (Extremely Important!)

Four broad approaches to exchange rate forecasting:

1 Purchasing Power Parity: movements in exchange rate should offset difference in inflation rates

2 Relative Economic Strength: focus on investment flows If investment opportunity is good capital flows in and currency strengthens

3 Capital Flows: Focus on expected capital flows (FDI and Equity Investments)

4 Savings-Investment Imbalances: Currency movement explained by domestic

savings-investment imbalances

4.7 Information Sources for Economic Data and Forecasts

• Take a look at Exhibit 33

• Good for the real world

• Not too useful for ‘exam-world’

Conclusion