CFA Level 3 (Chartered Financial Analyst)

Slide 1 : Capital Market Expectations Presented by: Aditya Ahluwalia www.finstructor.in

Capital Market Expectations : Capital Market Expectations Macro Expectations – regarding class of assets Micro Expectations – regarding individual assets Process Determine which expectations are needed Investigate historical performance and determinants of future performance Identify appropriate valuation model Collect the best data possible Interpret current investment conditions Formulate capital market expectations Monitor performance and use it to refine the process

Slide 3 : High quality forecasts are consistent, unbiased, objective, well supported, and have a minimum amount of forecast error Problems in Forecasting: Limitations to using economic data Timeliness, revisions, changes in index composition, rebasing of the index Transcription errors, survivorship, appraisal data Non stationary data Ex post data my underestimate ex ante risk Data mining bias, relationships due to random chance Conditioning information may be ignored Misinterpretation of correlations

Psychological Traps : Psychological Traps Anchoring Trap Status Quo Trap Confirming Evidence Trap Overconfidence Trap Prudence Trap Recallability Trap Model and Input Uncertainty

Forecasting Tools : Forecasting Tools Stastical Models Projecting Historical Data - Average Shrinkage Estimators – Weighted average Time Series Analysis Multi factor models

DCF Models : DCF Models

Grinold & Kroner Model : Grinold & Kroner Model

Risk Premium Approach : Risk Premium Approach

Financial Equilibrium Models : Financial Equilibrium Models

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Slide 11 : Use of surveys and judgement

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Cyclical Analysis : Cyclical Analysis Economic Growth Trend growth Cyclical growth Cyclical Analysis Inventory Analysis (2-4 yrs) Business Cycle (9 – 11 yrs) Measures of Economics Activity GDP Output GDP (current GDP – trend) Recession (2 consecutive quarters of decline)

Inventory Cycle : Inventory Cycle Inventory to Sales Ratio Increases before increase in employment and economic growth Periods subsequent to a peak in this ratios exhibit low economic activity Inflation Consumer and Business Spending (as a % of GDP consumer spending is much larger) Monetary Policy Fiscal Policy

Business Cycle and Asset Returns : Business Cycle and Asset Returns

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Inflation and Asset Returns : Inflation and Asset Returns Inflation increases when the economy expands Inflation declines when the economy slows Bonds perform well during low inflation unless credit concerns overtake Low/Moderate Inflation is good for equities Inflation above 3% is problematic for equities Real assets, real estate provide good inflation hedge

Taylor Rule : Taylor Rule

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Yield Curve : Yield Curve Both Expansive – Steeply upward sloping Both Restrictive – Downward sloping Mixed – Can’t say, monetary policy dominates short term segment

Economic Growth : Economic Growth Trend Growth Changes in Employment Changes in Productivity Changes in Employment Population growth Rate of labor force participation

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Changes to Economic Growth : Changes to Economic Growth Consumer Spending – Largest component, but doesn’t change much Government Policies Provide infrastructure, but interfere as little as possible Responsible fiscal policy – okay to stimulate sometimes, but can cause devaluation, crowding out Transparent, consistent and not overly burdensome tax policies Promote competition, reduce foreign tarrifs

Emerging Market Economies : Emerging Market Economies Responsible fiscal & monetary policies? – deficit to GDP greater than 4% indicates substantial risk Expected growth? – at least 4% Currency values and current account deficit? – overvalued currency may encourage excessive borrowing, deficit greater than 4% is problematic Highly levered? – debt > 50% of GDP or 200% of current account indicate high risk Forex reserves relative to short term debt? – should be more Government’s stance regarding structural reform

Linkages Between Economies : Linkages Between Economies Macroeconomic Linkages Exchange rates – Weaker country normally abandons the peg, hence interest rates are high Interest rate differential rates due to economic growth, monetary and fiscal policies

Economic Forecasting : Economic Forecasting Econometric Analysis

Slide 32 : Economic Indicators

Slide 33 : Checklist Approach

Economic Conditions & Asset Class Returns : Economic Conditions & Asset Class Returns

Slide 35 : Cash Instruments Short term, duration/credit calls taken by fund managers based on expectations Credit Risk free bonds Real yield + inflation premium Short term investor focuses on cyclical changes Higher economic growth implies higher yields Credit Risky bonds Favorable economic conditions result in lower risk premium

Slide 36 : Emerging Market Govt Bonds Need to acquire hard currency for pay back Need to analyze country risk Inflation Indexed Bonds Supply and demand drives yields Common Stock Emerging Market Stocks Higher and more variable returns, generally correlated with the developed world Real Estate Interest rates, inflation & yield curve effects prices

Forecasting Exchange Rates : Forecasting Exchange Rates

Slide 38 : Relative PPP PPP states that differences in inflation between two countries will be reflected in changes in the exchange rate between them Relative Economic Strength Favorable investment climate, higher short term rates, higher economic growth increases demand Capital Flows Approach Focus on long term capital flows (equity, FDI) Cut in rates may strengthen the currency & vice versa Savings – Investment Imbalances Approach If Investment > domestic savings, capital must flow into the country and currency must remain strong to attract the capital regardless of other factors

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