Chapter 19 Global Economic Activity and Industry Analysis

Chapter 19 Global Economic Activity and Industry Analysis

Chapter 19 Global Economic Activity and Industry Analysis Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 19-1 Global Economic Activity and Industry Analysis Our goal in this chapter is to answer some general questions about economic activity. For example: 1. 2. 3. 4.

What is the business cycle? How is economic activity measured? What is monetary & fiscal policy? How does economic activity impact sectors of the economy and the firms in these sectors? Answering these questions might help us anticipate economic movements. Might be valuable for deciding which investments to choose for a particular time period. 19-2 Top Down Analysis, I. Some money managers use a bottoms-up approach to

select securities. This approach does not use: Perceived economic cycles Industry specific information The more common style is called top-down analysis. Take a big picture perspective of the global economy. filters & sorts potential investments into smaller groups. This process is like a funnel: All possible investments go in at the top. Based on economic, industry, & company analyses, the money manager identifies the best potential investments. 19-3

Top Down Analysis, II. 19-4 Gross Domestic Product, GDP GDP is the market value of goods & services produced over a time period. GDP is an indicator, of the standard of living for people in a country. Nominal GDP: dollar value of output in the current year. Many economists prefer to focus on real GDP. Real GDP is nominal GDP adjusted for inflation. o makes it easier to compare standard of living across time The Lesson: If investors use expected growth rates to decide

on country investment levels, real GDP is a much better measure of true economic growth than nominal GDP. 19-5 GDP versus Market Capitalization 19-6 U.S. Real GDP (wheres the cycle?) 19-7 U.S. Real GDP Growth (The Cycle is in GDP Growth)

19-8 Business Cycles When estimating GDP growth, investors need to be aware of the business cycle. A nations GDP levels go through periods of ups & downs In a national economy, this up and down movement is called the business cycle The stage of the business cycle affects the profitability of industries The 4 stages of the cycle include: peak, contraction, trough, and expansion. The figure suggests that the business cycle follows a rather smooth pattern, but reality is not so simple.

19-9 Phases of the Business Cycle 19-10 Economic Indicators Smart investors must be able to identify the economic indicators that help them make accurate forecasts of future economic conditions. Most economists rely on a group of leading economic indicators for this information. Tend to rise or fall in advance of rest of economy o Stock-market-price index

o Money supply o Manufacturers orders The other indicators used to gauge economic activity: lagging indicators & coincident (i.e., simultaneous) indicators. 19-11 Leading, Coincident, & Lagging Economic Indicators 19-12 The Domestic Macroeconomy Unemployment Rate: Ratio of number of unemployed to total labor force Budget Deficit: Government spending in excess of

government revenues Sentiment: Consumer optimism/pessimism are determinants of economic performance Demand Shock: Event that affects demand for goods & services in economy Supply Shock: Event that influences production capacity & costs in economy 19-13 Interest Rates High interest rates reduce present value of future cash flows Fundamental Factors of Interest Rates 1. Supply of funds from savers 2. Demand for funds from borrowers 3. Governments net supply/demand for funds, modified

by Federal Reserve 4. Expected rate of inflation 19-14 The Effects of Exchange Rates on Global Investments, I. Suppose we have $10,000 to buy shares of a company listed on the Europe. We need Euros to make this investment. At the beginning of the year the exchange rate is $1.39/. The shares increase in value by 10% during the year. Convert the euros into dollars at a rate of $1.28/. What is our net dollar return? The asset itself had a positive return. But, what about the impact of the exchange rate? We held euros: Did they appreciate or depreciate relative to $US?

The euro depreciation means that the net return wont be 10% The asset return is reduced by the depreciation of the euro As with any asset, we want to invest in currencies that are appreciating. 19-15 The Consumer Price Index Inflation: Rate at which general level of prices for goods and services is rising The Consumer Price Index (CPI) is the measure inflation. uses the average price of a fixed basket of goods & services. the percentage change in the CPI from one period to the next.

This negative correlation between inflation & Real GDP. means high inflation hurts real economic growth. High inflation leads to higher interest rates. Lenders will demand a higher interest rate to compensate for their loss in purchasing power. High interest rates tend to reduce the demand for loanswhich, in turn, reduces economic growth. 19-16 U.S. Real GDP Growth & CPI 19-17 Monetary Policy

The money supply is important for the economy because it represents the gas for the economic engine. o Giving the economy more gas (i.e., more money) makes it go faster o Giving it too much money, can result in overheating (ex: high inflation) The goal should be to keep the money supply growing at the pace to keep the economy moving forward at the desired rate. Actions taken by the central bank to influence money supply or interest rates A positive relationship between money supply growth & stock prices. 19-18 The Federal Reserve (of the U.S.) /The Central Bank

bankers bank provides loans & holds deposits (for banks) Regulates banks & monitors & changes the money supply. o Theoretically, an independent governmental agency. Goals of the central banks: keep inflation in check, generate full employment, moderate the business cycle, & help achieve long-term economic growth. Primarily relied on its ability to change interest rates. Has control over the discount rate, the interest rate charges its member banks on loans. All else equal, reducing the discount rate should stimulate demand for loans, which in turn, prompts economic growth. 19-19 Fiscal Policy

Fiscal policy: The tax rates & government spending Budget deficit: when expenditures exceed revenues Over time, these budget deficits grow & increase the debt, because excess spending must be paid for with borrowings. In theory, the debt finances government spendingpart of GDP. Some believe that increased spending actually grows economic activity. The downside of debt, however, is that it must be repaid. In the long run, continued debt implies higher interest rates & increased taxesslowing growth. To pay off debt, governments could simply print money (lead to inflation) For an investor, national debt can be a critical factor in

19-20 Country Debt, 2010 Note: This recent debt level in Spain has been viewed as burdensome for economic growth. 19-21 Industry Analysis There are Many Ways to Define a Sector A good starting point is the list of 10 basic sectors used by Standard and Poors, the creator of the S&P 500 Index. Some sectors are quite small (Ex: telecommunications & utilities) Other sectors (such as financials & technology) are quite large.

While these weights are not extremely volatile, they do change when some sectors do well relative to other sectors. In early 2007 financials comprised over 20% of the index weight. Less than 15% of the index following the financial crisis Understanding the reasons behind these movements could give you an advantage, and maybe it gives you a way to weight your portfolio. 19-22 Ten Sectors of S&P, April 2012 19-23

Return on Equity, 2011 Computer systems 36.4 Restaurants 29.6 Application software 24.9 Industrial metals

24.6 Chemical products 19.6 Integrated oil & gas 18.1 Health care plans 17.2 Aerospace/defense

17.1 Pharmaceuticals 15.8 Home improvement 15.6 Telecom services 14.1

Business software 11.4 Asset management 10.3 Food products 9.0 Biotech 8.7

Trucking 8.5 Auto manufacturers 7.9 Electric utilities 7.1 Heavy construction

7.0 Money center banks 6.7 0.0 5.0 10.0 15.0 20.0

25.0 30.0 35.0 40.0 19-24 Industry Analysis Sensitivity to the Business Cycle Sensitivity of sales

Necessary product or luxury? Low sensitivity to income Operating leverage Financial leverage 19-25 2011 2009 15%

2007 2005 2003 2001 1999 1997 1995

1993 Annual sales growth (%) Industry Cyclicality Grocery Jewelry 10% 5% 0%

-5% -10% -15% 19-26 Rotational Investing Macroeconomic trends & government actions can favor some industries more than others. Some investors might believe that if the S&P 500 return is positive, then the returns for all sectors must be positive. It is possible for some sectors to have a negative return over a given period even if the entire index has a positive return.

So, active investors will decide to enter & exit industries. Sector Rotation: (rotational investing ) Shifting portfolio into industry sectors expected to outperform others based on macroeconomic forecasts 19-27 Sector Rotation 19-28 Making Cyclical & Defensive Investment Decisions: Where will the Business Cycle go? Sectors have different sensitivities to the business cycle. Analysts often refer to cyclical / defensive sectors

Cyclical Sectors(Ex: industrials & materials) Have above-average sensitivity to the business cycle. A cyclical company is one that performs relatively better in a climate of strong growth. Defensive sectors (Ex: health care & consumer staples) Have relatively little sensitivity to the business cycle. A defensive company is one that performs relatively better in a climate of weak growth. 19-29 S&P 500 Sector Returns (as of 4/23/2012) 19-30

Subsector (Industry) Differences The 10 S&P sectors have its limitations. Ex, would you group Disney & Ford Motor in the same sector? o Disney is in media, and Ford is in automobiles. o Yet, S&P puts them both into the Consumer Discretionary Shows that sophisticated industry analysis often involves drilling down to uncover more detailed information. One way is to make comparisons across subsectors. These subsectors are often referred to as industry groups. Ex: to use the Global Industry Classification System (or GICS). Begins with the 10 S&P sectors, but it then subdivides them into 24 industry groups, 67 industries & 147 sub industries. The GICS allows for a more defined comparison across firms.

19-31 Industry Analysis 19-32 The Industry Life Cycle There are other factors that lead investors to rotate sectors. Industries often follow this life cycle: 1. Start-up stage: Often characterized by new technology/product 2. Consolidation stage: Industry leaders begin to emerge 3. Maturity stage: Product has reached potential for use by consumers 4. Relative decline: May grow less than rest of economy

Each industry is different & the stages can vary in length. By understanding an industry life cycle, investors might be able to identify which companies are poised for higher growth and which ones are likely to fade away. 19-33 The Industry Life Cycle 19-34 Industry Analysis: Porters Five Forces Once investors have narrowed down the industries in which they are interested, they undertake some additional analysis. One particularly helpful approach is to use Porters Five

Forcesnamed after strategy guru Michael Porter. The goals of using the Five Forces: Estimate then competitive level in an industry Identify which firms might be best positioned for success 19-35 Porters Five Forces Model of Competition 19-36 Porters Five Forces, II. 1. Threat of new entrants: How easy is it for new firms to enter the market? High barriers to entry impacts how likely a firm retains market share. 2. Bargaining power of buyers: How difficult to switch to another seller?

The easier it is to switch, the more pricing pressure (profit margin.) 3. Bargaining power of suppliers: How easy is it to raise prices? The easier it is to raise prices, the hard to control costs (profit margin.) 4. Threat of substitute products: How easy to substitute another product? Ex, if beef prices increase significantly, a you could switch to chicken. Firms face competition from products outside their specific industry. 5. Intensity of rivalry : Rate competitive intensity within the industry. Identify which industries are most likely to retain market share. Retaining/gaining market share to grow profits (increase the stock price). 19-37 Useful Internet Sites (for data on current economic conditions) (exchange rates and a currency converter) (for a running tab of US federal government debt) (to see the current heat map) (learn about GICS under index resources) (check out the economic moat rating) (reference for the latest financial information) 19-38

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