Economics
2. The economic incentives for domestic importers decrease (their currency, used to purchase foreign goods, is decreased in value), while the fortunes of domestic-based
In summary:
Value of Dollar Exchange Rate (U.S./Foreign
Currency)
Foreign Goods Purchased with
U.S. $
U.S. Goods Purchased with Foreign Currency
Increases Increases Less expensive More expensive
($ buys more of foreign currency)
Another example can clarify this important notion:
1. A Japanese car manufacturer exports cars to the United States, and expects to receive
In summary:
value of Dollar Exchange Rate (U.S./Foreign Currency)
Foreign Goods Purchased withU.S. $
U.S. Goods U.S. GoodsPurchased withForeign Currency
Decreases Decreases More expensive Less expensive
($ buys less of foreign currency)
There may be several different cause-and-effect reasons for a particular currency to appreciate or depreciate vis-à-vis another currency. Methods to forecast exchange rates are firmly embedded in theoretical and restrictive assumptions about how perfect and efficient trading (of goods, services, and capital) between nations is assumed to be. In the real world, however, these assumptions are lifted to reveal many uncertainties about the future growth and impact of
inflation, and the effects on the currency markets. An evaluation of these restrictive assumptions yields some intriguing facts:
• Goods cannot be transferred between nations instantly.
• Shipping costs are prohibitively high.
• Import restrictions (tariffs and quotas) affect international trade.
• Cultural differences make consumption standardization between nations very difficult, and usually drastically flawed.
International parity conditions are explored in greater detail in the appendix to this chapter including the discussion of interest rate arbitrage as well as problem sets to sharpen skills in this area.
Government Releases and Indicators
The economic information released by the government periodically, collectively known as indicators, supposedly indicates the health of the economy. My skepticism is a by-product of the very nature of these releases (usually representative of a lag of 1 to 2 months) and the empirical evidence that supports the notion that even with all this information at their computer-tapping fingertips, economists have a pretty difficult time being consistently accurate with their macroeconomic views.
Although the current process of economic releases is better than in most developed countries, small inconsistencies remain, including the revision procedure and the measurement protocol for many of the more
What Is Inflation?
You probably can think of a description or even a definition of inflation—it is what you feel when you go to the checkout counter at the supermarket. When I find myself enduring this experience (in my household, thankfully, about once every three months), the numbers just fly by in some type of exponential gaze. I usually ask the checkout operator, armed with the newest in bar technology, to slow down (and I am often in a rush) because I think there is a problem with the machine. How could these prices be so high if the CPI just came out last week and registered a decline in the core rate of inflation? The price on that cereal box must be a mistake! How much per pound for those mangoes?
Empirically, the inflation effects on interest rates, known as the "real" rate, is simply the product of the nominal interest rate and the inflation rate, seen as:
Nominal interest rate = Real interest rate x Inflation rate
This equation is embedded in the theory known as the International Fisher Parity Condition.
If the rate of inflation is 4% and the nominal rate was 6%, what is the real interest rate?
We could use some algebra to get:
6% = 4% X which equals 1.5%
Or we could apply the approximated linear relation:
Nominal rate = Real rate + Inflation
We get a lower number when actually calculating the multiplication instead of the arithmetic because multiplication affects numbers faster and more significantly than arithmetic. The simple reason for this is that elusive tenet of finance known as compounding.
Two economic views differ significantly on the subject of real interest rates:
• Fluctuations of interest rates are caused by revisions in inflationary expectations, since real rates are very stable over time. As explained by Alan Shapiro (1992), "If the required real return is 3% and expected inflation is 10%, then the nominal interest rate
(continued)
What Is Inflation? (Continued)
would be 13.3%. The logic behind this result is that $1 next year will have the purchasing power of $.90 in terms of today's dollars. Thus, the borrower must pay the lender $0.103 to compensate for the erosion in the purchasing power of the $1.03 in the principal and interest payments, in addition to the $.03 necessary to provide a 3% real return" (Multinational Financial Management, 4th ed.).
• Keynesians' provide a different view: Monetary shocks leave shortterm inflation unaffected because of
"sticky" goods prices (prices take time to adjust to inflationary pressures), whereas real rates react
immediately to liquidity conditions. For example, if a sudden contraction in money supply growth leads to an immediate increase of nominal interest rates, then the real interest rate will increase because money becomes rare while short-term inflation expectations are unchanged.
important releases. However, there is a continual effort for improvement in this critically important area; most recently, the Boskin Commission has embarked on the monumental task of rethinking the measurement of the critically important inflation measure known as the Consumer Price Index (CPI). Although the details of the commission's findings will not be final for some time, the economic data release process is as reliable and accurate in the United States as any other developed nation. Can it be improved? Of course, what government- related activity can't benefit from some improvement? In the United States, the market (and its participants) demand the most accurate information possible from the suppliers of this data.
How should the investor use the multitude of economic data that is reported each day? Which reports are important and which are not? What effect does an economic report have on a given portfolio? The effect depends on the type of portfolio (equity or debt) and the magnitude and direction of the economic release. The simple rule of thumb is this: As the economy expands, pressure exists on the Federal Reserve to increase short- term interest rates to mitigate any potential inflationary effects. As interest rates increase, the present value of future earnings decreases and thereby the value of financial assets, which are based on the present value of future cash flows, also decreases. So, in a nutshell, as the economic reports "hit the tape" the investor must decipher whether the report is above or below consensus estimates (an average of the Wall Street community's
economists forecasts) and furthermore whether this portends an expanding or contracting economy.
One way to think of this mechanism is by relating the economy to a car engine—the more gas the driver gives (by stepping on the accelerator), the more the engine will rev, and if the engine revs up too fast for too long, it will overheat. With the economy, liquidity (or capital) is the fuel, interest rates act as an accelerator to the economy (lower rates accelerate economic activity, higher rates slow activity) and inflation is the symptom of an overheating economy. So the question for the investor monitoring the economy should be whether the economic release signals increased or decreased economic activity and whether a trend up or down can be determined over several releases.
The investor should also pay attention to the specific industry being studied to determine its current economic picture. The economy does not move in lockstep but is segmented, and consequently certain sectors will grow at different rates and times than others. For example, the housing market could be in a growth pattern, evidenced by the upward trend of new home sales and housing
starts/building permits, but the manufacturing sector could be registering a slowdown, evidenced by a downward trending National Association of Purchasing Managers (NAPM) report. While the investor holding shares in home-building companies would be expected to receive a positive outlook for the earnings of these companies, the effect of this growth could affect an increase in interest rates and thereby reduce the demand for new homes (due to increased mortgage rates). This two-tiered
guessing game keeps Wall Street's cadre of economists, analysts, and strategists busy each weekend.
In its basic form, stock prices move up or down depending on two factors—earnings and interest rates; as explained in Chapter 5, the current value of an equity is the present value (using a discount rate) of future cash flows (earnings).
In evaluating the economy as a whole, how does an investor know which indicator should be analyzed to base his decision of interest rate forecasts? Which indicators are more sensitive to the inflationary threats in the economy? Enter the Federal Reserve; a group of top economists,
practitioners, and academics who attempt to determine the temperature of the economic engine.
Perhaps an increase in housing data is due to some seasonal affect, or perhaps it is just consequence of an enduring period of low interest rates and high personal savings. Maybe, at this current juncture, the increase in housing data is being met with
How the Federal Reserve Works If the Fed wants to stimulate the economy:
• Decrease in federal funds rate. This is the rate set by the Fed for overnight loans between member banks, so they can meet their reserve requirements. These loans are typically made to smaller, regional banks by larger, commercial banks.
• Decrease in discount rate. This mechanism is rarely used and that is perhaps why it receives such fanfare when it is used. The discount rate is the rate charged to member banks for loans directly from the Fed.
• Federal Open Market Committee (FOMC) activities: If the Fed requires its member banks to hold more capital in reserve, that action provides more capital for the bank to lend out to customers thereby stimulating the economy and lowering the cost of capital (interest rates). The mechanism used in this procedure is the Fed's buying of U.S. Treasury securities from the member banks, thereby increasing the member bank's reserves.
If the Fed wants to restrict economic activity:
• Increase in the federal funds rate. As with anything, if you desire to decrease demand of any good, in this case capital, you need only to increase its price, in this case, interest rates. An increase in the federal funds rate would make banks more prudent with their reserves so that they would not have to borrow at the higher rates. A bank would be less likely to make a borderline credit quality loan, because if the bank fell short on reserves and had to borrow, the costs of this borrowing would have a negative impact on its profits.
• Increase in the discount rate. Like the preceding, an increase in the discount rate would also have a contractory effect on the banks' profit margins and therefore would be expected to slow down lending activity. Once again, if businesses are unable to obtain capital inexpensively, they may choose to postpone their plans for expansion, new equipment, or new employees. This type of action has its impact throughout the economy.
• FOMC activities: Here, the Fed sells U.S. Treasury securities to the member banks (which are required to buy a predetermined amount) thereby reducing the capital that the banks have on deposit and consequently available to lend.
sufficient supply and therefore, price pressures are not much of a concern.
The preceding musings are, I expect, the type of discourse that is often analyzed by Federal Reserve governors and their staffs. An investor should be aware of the Fed's current concern and the
indicators that relate to this concern. Recently, the Fed has been most concerned about the 30-year low in the unemployment rate, which typically, in the past, has been a portend of higher economic activity (the more people making money, the more they can spend) thereby increasing the threat of inflation. The Fed's current infatuation with inflation has made the markets quite sensitive to swings on the mornings that employment data are released (especially the "employment cost indicator").
Several years ago, the "release-of-concern" was the deficit data and prior to that the trade-gap data.
The point here is important—the Fed is as fickle as the economy and therefore an investor needs to be aware of the current "indicator-du-jour" to understand how the impact of a certain release will affect the market. It is important to differentiate the investor's concern with economic releases with regard to the effect on the market and on an investment portfolio. A word of caution to the investor who is under the impression that an understanding of economic indicators is the key to the temple of investment outperformance: Economic releases are volatile and fickle. An investor cannot fully rely on one dataset to make a decision, but must assemble a bevy of releases (over time) to make an effective analysis of expected future conditions. That is not to say that the market itself will be so tempered in its reaction to the latest economic release—the traders, who make their living on volatility and volume, will ensure that any reaction is anything but boring.
In addition to the fickleness of the market and uncertainty about the importance of economic releases, the media romanticize each tiny movement as an earth-shattering development. This is not to say that the increased awareness of financial information, due to the different media sources (cable television.
Internet sites, and dedicated financial radio stations) is a negative. Just the contrary, it probably accounts for more of the increase in individual investor participation than any other single source.
However, my concerns lay with the media's overemphasis on the economic report of the day, challenging the investor to make decisions based on this volatile information flow. While this
information is pertinent to traders and speculators of this fast-money ilk, it may not be material to the investor who has a farther investment horizon. However, the investor should not ignore this data, for when analyzed over some period, it can provide insights to the economy on a whole as well as
specific industry sectors.
Keeping with the function of this book, we have provided details of only the most important economic releases. For simplicity and ease of use, 42 different economic indicators typically monitored by Wall Street investment firms are organized into 13 different categories:*