UNSW Business School
School of Banking and Finance
FINS5568 Capstone – Portfolio Management Process
Lecture 4: Economic, Industry and Factor Analysis
Prepared by Susan Rui Sun & Yufeng Yao
Lecture Outline:
• Introduction of economic and industry analysis
• Business and inventory cycle
• Economic growth trend
• Industry analysis
• Factor investment
• Factor construction
• Reading:
• Maginn, et Al. chapter 4, Reily et al. 2012, chapter 9
Introduction
The goal of economic and industry analysis
• Economic analysis help analysts understand the historical relationship between economic
variables and capital market returns
• Concerning the direction, strength and lead-lag relationship
• Give an analyst many advantages, for example they can better discern or forecast the inflection point
that presents unique opportunities
• Industry analysis
• Different industries have different return and risk drivers
• Firms within an industry tend to be affected by similar forces
• Classifying companies using industry provide better discipline and tend to be a good starting point
• Most research house assign analysts to cover specific industries
Economic Analysis
Economic
analysis
introduction • Economic output tends to have both cyclical and trend
growth component
• Trend growth component determines the long-term
return expectation for asset classes, such as equity
• Cyclical components affect the short-term corporate
profits and interest rate, which affect stock and bond
return
• Within cyclical analysis
• Inventory cycle: short-term, 2 - 4 years
• Business cycle: long-term, 9 - 11 years
Economic analysis – Cyclical analysis
Measure of economic activities and output:
Gross domestic product (GDP)
• Total value of final goods and services produced within a country’s borders in a specific period
• Under the expenditure approach: sum of the final uses of goods and services, including consumption,
investment, changes in inventories, government spending and exports minus imports
• Economists focus on real GDP, adjusting for the effects of inflation
Economic analysis – Cyclical analysis
Output gap:
• The difference between the actual value of GDP and the potential output
• Potential output: GDP estimated as if the economy were on its trend growth path
• Affect the future inflationary pressure
• Negative gap: during recession or slow growth - downward inflation pressure (suppliers reduce prices to
sell inventory as the demand is not strong)
• Positive gap: during good economic conditions – spurs inflation (higher demand and price of labor and
goods increase)
Recession:
• Broad-based economic downturn
• Two successive quarterly declines in GDP (negative growth)
Economic analysis – Cyclical analysis
Inventory cycle
• Often measured by inventory to sales ratio
• Increase when business have confidence in the future economy and increase inventory to satisfy
future demand – employment also tends to increase – economy tends to grow
• At certain point, the measure peaks before subsequent economy slowdown – businesses sell
down inventory and cut production
• When the measure bottoms, the economy tends to be strong in the next few quarters
• Long-term trend going down due to more effective inventory management techniques, such as
just-in-time inventory management
• Order laptops online and will deliver to you within 2 weeks
Economic analysis – Business cycle
Business cycle
• Reflects the fluctuation of GDP in relation to long-term trend growth
• Business cycle and asset return relationship is well-documented
• Five phases: initial recovery, early upswing, late upswing, slowdown and recession
• Each cycle is different because of specific events and trends – the phases are different in terms
of duration and severity
Economic analysis – Cyclical analysis
Initial recovery
• Duration of a few months
• Business confidence is rising
• Government stimulation by lower interest rate and/or budget deficit
• Large (negative) output gap and falling inflation
• Asset class returns:
• Bond yield at the bottom (price is high)
• Rising stock prices
• Cyclical, riskier assets (small-cap stocks and high yield corporate bonds) do well
Economic analysis – Cyclical analysis
Early upswing/expansion
• Duration of a year to several years
• Increasing growth with low inflation
• Increase confidence and inventories by companies
• Rising short-term interest rates – central banks withdrawing monetary policy support
• (Negative) output gap is narrowing
• Asset class returns:
• Flat or rising bond yield
• Rising stock prices
Economic analysis – Cyclical analysis
Late upswing/expansion
• Confidence and employment are high
• Output gap closed, inflation increases and the economy is at risk of over-heating
• Central banks tend to further tighten monetary policy and rising short-term interest rates
• Asset class returns:
• Rising bond yield
• Rising/peaking stock prices with increased risk and volatility
Economic analysis – Cyclical analysis
Slowdown
• Could last from few months to a year or longer
• Business confidence falling and reducing inventory
• Inflation is still rising due to positive output gap
• Short-term interest rates are at peak
• Asset class returns:
• Bond yield have peaked and start to fall with rising prices
• Falling stock prices
• Inverted yield curve (short-term yields are higher than the long-term ones)
Economic analysis – Cyclical analysis
Recession
• Six months to a year
• Decline in inventory, confidence and profits
• Increase in unemployment and business bankruptcies
• Inflation tops and start to fall
• Asset class returns:
• Falling short-term interest rates – central banks monetary support
• Falling bond yield (rising prices) – investor fly to safety
• Stock prices tend to go down until near the end of the recession
Economic
analysis –
inflation
Inflation
• Inflation means rising prices (decreasing purchasing
power of currency unit) and deflation means falling
prices
• Commonly measured by consumer price indices (CPI):
price of a basket of goods and services
• Central banks try to keep inflation low without
succumbing to deflation
• High inflation is harmful to the economy
• Uncertainty about purchasing power of money -
discourages investment and savings
• Very high inflation can lead to social unrest and revolt –
basic goods and services not affordable
• Redistribution purchasing power from those with fixed
nominal income (such as pensioners) to those with
variable income (workers whose salary increases with
inflation)
• High inflation has been defeated mostly by the end of the
twentieth century
Economic
analysis –
inflation
• Inflation tends to accelerate in later stages of business
cycle when the output gap has been closed
• Inflation falls during a recession or early years
afterward – large output gap
• Deflation can be a threat to the economy because:
• Undermines debt-financed asset (such as home
property) and encourages default
• Imagine you purchased a house with $1 million with a
$900,000 mortgage but find next year the property is
only worth $800,000.
• Reduces central banks ability to stimulate the
economy through reducing interest rate as nominal
interest rate can be very low or close to zero due to
deflation.
• Leaving less room for central banks to further reduce
nominal interest rate
Economic analysis – inflation and asset class
returns
• Inflation above expectation – inflation shocks:
• Cash (positive): rising rates to compensate the higher inflation
• Bonds (negative): higher yield due to higher inflation premium
• Equity (negative): generally perform better than bonds as companies can potentially pass
on the inflated costs to customers but rising inflation could lead to recession and central
bank tightens policies, which is negative for equities
• Real estate and other real assets (positive): asset value (price) and cash flow tend to
increase
Economic analysis – factors affect business
cycle
Consumer and business spending:
• Consumer spending amounts 60-70% of GDP for most developed economies and therefore
most important business cycle factor
• Data: retail sales and store sales data, tend to have seasonal patterns
• The most important factor affecting spending is income after tax
• Business spending
• Smaller share in GDP compared to consumer spending
• But more volatile – business investment can fall by 10-20% or more during recession
Economic analysis – factors affect business
cycle
Monetary policy:
• Central banks use monetary policy to adjust the performance of the economy
• The goal is to keep growth near long-run sustainable rate
• Expansionary monetary policy:
• Increase money supply and/or decrease interest rate – encourage business and individual borrowing
and spending, also can lower exchange rate and stimulate exports
• Applied during recovery and early upswing phase of the business cycle
• Contractionary monetary policy:
• Decrease money supply and/or increase interest rate
• Applied during late upswing
Economic analysis – factors affect business cycle
Monetary policy – predicting central bank behaviour with the Taylor rule
= + + 0.5 − + 0.5( − )
• central bank targe nominal short-term rate
• short-term interest rate that would be achieved if GDP growths were on trend and
inflation on target
• Example 1: What is the short-term interest target if the neutral rate is 2%, inflation target is 2%,
expected inflation is 4%, GDP long-term trend is 2.5% and the forecasted GDP growth is 3%
Solution: 2 + 4 + 0.5(4-2) + 0.5(3-2.5) = 7.25%
Economic analysis – factors affect business
cycle
Fiscal policy:
• Government can intervene in the economy through fiscal policy: spending and tax rates
• Expansionary fiscal policy:
• Decrease tax – leave more money to individual and business for spending
• Increase government spending – directly increase the demand for goods and services
• Contractionary fiscal policy:
• Increase tax and/or decrease government spending
• Spending greater than income will lead to government budget deficit
• Importantly, it is the change in government spending matters
• Changes in government deficit that occurs naturally during business cycle are not stimulative or
restrictive
Economic analysis – factors affect business
cycle
Yield curve:
• Relationship between interest rates and maturity of debt securities
• Typically upward shape - longer maturity security need to offer higher return for investors –
loss of liquidity, greater interest rate risk
• Inverted yield curves have been strong indicators of economic recession
• In anticipation of economic downturn, investors buy into long-term safe assets
• Drive up the price and long-term asset – lower yield
Economic analysis – factors affect business
cycle
Yield curve:
Economic analysis – factors affect business
cycle
Yield curve:
• Sensitive to government policy and economic conditions
• Expansionary/stimulative fiscal and monetary policy: upward sloping and economy likely to expand
• Contractionary/Restrictive fiscal and monetary policy: downward sloping and economy likely to
contract
• Conflicting policy: flat or moderately steep (if monetary policy is stimulative) and the impact on
economy is less clear
• Within business cycle:
• Steep at the bottom of the cycle, flatten during expansion, flat or inverted at the top of the cycle
Economic analysis – economic growth trend
Economic growth trend:
• The long-term growth path of the economy – average growth rate around which the economy
cycles
• Economic trends exist independently of the cycle but are related to it
• It is key input in the discount cash flow models of expected return
• The simplest way to estimate the growth rate is to split aggregate growth trend into:
• Growth from changes in employment – labour inputs
• Growth in potential labour force size
• Growth in actual labour participation
• Growth from labour productivity
• Growth from capital inputs
• Total factor productivity (TFP) growth
Economic analysis – economic growth trend
Example 2: Given the following information, what is the forecast economic growth trend?
✓Growth in labor force participation: 1.5%
✓Growth in labor force size: 2%
✓Growth in capital input: 1%
✓Growth in TFP: 0.5%
Solution: 1.5% + 2% + 1% +0.5% = 5%
Economic analysis – economic growth trend
Government structural policies: policies that affect the limits of economic growth and
incentives within private sectors:
Pro-growth structural policies:
1. Sound fiscal policy: limited budget deficit and reduce the burden of interest
2. Minimal government intrusion on the private sector and encourage competition in the private
sector - free market tends to more efficient in resource allocation
3. Develop infrastructure and human capital through education and training
4. Sound tax policies
Industry Analysis
Industry analysis
• Different industries perform differently during different stages of business cycle
• Industry/sector analysis facilitates sector rotation strategy – better predict industry performance
• Improve within industry security selection – identify drivers of industry performance and select
securities that benefit the most
• Typical patterns of industry performance during business cycle
• Financial stocks often recover first towards the end of a recession
• Consumer durable goods do well as the economy recovers
• Cyclical companies tend to move in anticipation of business cycle
• Consumer staples tend to outperform during downturn
Industry analysis
• Can examine the variables that drive performance:
• High inflation often benefits basic material stocks
• High interest rates hurt housing and construction
• Weak domestic currency helps exporters
• Low growth rates tend to help few companies that can deliver high growth
• High energy costs hurt transportation companies, such as airlines
• Note that sector rotation strategy might be difficult as each business cycle is different
Industry analysis
• Structural Economic changes impact the industry:
• Demographics: aging population, shrinking middle-class, and racial and ethnical diversity
• Lifestyle: reading habit of different generations, divorce and single parent family
• Technology: Amazon’s impact on retail, Uber on local transportation, Airbnb on hotel
• Politics and regulation
Factor Analysis
Factor analysis - Introduction
• Factors are broad and persistent drivers of return and risks of securities:
• Arbitrage pricing model (APT) – Stephen Ross, 1976
• There exist multiple factors as compared to the single market factor in CAPM
• Equities:
• Small size (small firm outperform big firm)
• Value (value stocks output growth stocks)
• Momentum (past winner tend to outperform losers)
Factor analysis - Introduction
• Factors can be captured in systematic and cost-effective ways
• Earlier years, factor investment is mostly used by hedge funds
• Nowadays, there are numerous smart beta investment funds/ETF:
• Target single or multiple factors
• Generate extra return but low cost and transparency of index investment
• Factor performance can be cyclical:
• Momentum: outperform in expansion
• Quality: outperform in economic slowdown and recession
Factor analysis – Smart Beta
• Why “smart beta”?
• Beta refers to the exposure to systematic risk factors
Factor return
• Two broad methods to construct factor portfolio and calculate returns in practice
• Method 1:
• Sort stocks based on characteristics and construct long-short hedged portfolios
• Example: Fama-French value-growth, size factor, Carhart Momentum factor
• Ken French factor library:
https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
• Example: see the FF_size_factor_demo.xlsx
Factor return
• Method 2:
• Multi-factor models: pre-defined factors
• Example: multifactor.html
• More consistent with the APT theory and enables the construction of pure factor mimicking portfolio
• The impact of all other factors are controlled
Summary
After this lecture, you should understand
• Key economic measures in economic analysis
• Inventory and business cycles and their basic
characteristics
• Understand factors that affect business cycles
• Forecast economic growth trend
• Common industry characteristics during business
cycles
• The concept of factor investment
• Two methods to construct factor portfolios