Macroeconomic concepts all investor must know

Macroeconomic concepts all investor must know

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all macroeconomic concepts

1.- Introduction to Macroeconomics
2.- Economic activity; The economic cycles
3.- Types of GDP and its appliances in the macroeconomic scenario
4.- Price Development: Inflation and deflation
5.- Market expectations and Prediction of the Economic cycle
6.- Economic Predictions based on juncture indicators

The Macroeconomic field studies the overall functioning of an economy as a whole, without emphasizing in the specific behavior of different sectors or actors in each market separately. The main objective in  macroeconomics is to explain the evolution of economic aggregates in the market such as gross domestic product, the general level of prices or the unemployment rate. These aggregates are the result of group behaviors of different individuals and actors in different markets. By contrast, microeconomics is concerned with the analysis of individual behavior of actors (producers, consumers) and their interaction in particular markets.

1.- Introduction to Macroeconomics

In all markets, prices are established by the level of economic activity. There are many other factors, but generally when the economy grows prices go up, and vicebersa. That process of a generalized increase in the price of goods and services it is called Inflation.

Inflation is a very important concept to understand from the very beginning, because it is going to bother us during our whole life. Inflation has a reason to exist, it is a natural phenomenon of the economy. It happens when the economy of a country reaches its top level of production. If the demand keeps growing, companies can’t produce more goods and services in a short period of time because each extra unit of production would be too expensive at that point. So they rise prices to increase revenue. The consequence of that phenomenon is that Central Banks rise nominal interest rates during peak times to control inflation. And when prices go up, the value of each unit of money decreases. That is why a hundred years ago the average wage for industrial workers was around $450/year.

The growth of the economy is cyclical. So, by knowing the actual situation of the economy and being able to predict the future trends in the mid-short term the investor will have a competitive advantage in the market.

macroeconomic capital entrerprise

2.- Economic activity; The economic cycles

Historically has been seen that economic activity is not constant. The economic activity it’s based on cycles. Periods of time where the economy grows and others decreases. The breadth of the cycles is not constant either. So, it is important to be aware of what happens in and around the economy, in order to come up with a reliable conclusion.

Big events can change these cycles, and the breadth of it.

  • Wars (WWl, WWll…)
  • Technologic changes (computers, planes, telephones…)
  • Energy changes (oil, gas, etc..)

Phases in a cycle; The basic phases of a cycle are the following 4:

  • Peak
  • Contraction
  • Depression or Valley (only exists if the economy shrinks for more than 2 consecutive quarters)
  • Expansion

macroeconomic cycles

macroeconomic cycles diagram

Duration and Depth of a cycle

  • Duration: Time that takes to go from one peak to the next one

Or from Valley to Valley.

  • Depth: It’s the dispersion between the reference (average) growth. It can be calculated either by the 0% method or the tendencial growth method.

Interpretation of the Main indicators during the economic cycle:

During Phase of Expansion:

  • Sustained growth in GDP
  • Increased consumption: Mainly private
  • Sharp prices of goods and services increased (inflation)
  • Steady increase in wages above the purchasing power.
  • Sustained increase in corporate profits
  • Increasing the marginal propensity to indebtedness.

stock trading track

In the graph it is represented a stock trading track record during an expansion phase. Where numbers 1 and 3 show a clear increase in price, with a correction in the middle represented with number 2. At the end of the phase we find number 4, showing a peak price, where it is not likely to overtake it in the short term.

Market behavior during expansion phase:

  • The currency tends to appreciate over blocks of lower growth
  • Money market rates tend to rise, liquidity preference
  • Public debt: interest rate hike; underweight and bias towards the short term
  • Per Private fja: Improving credit quality softens the effect of risk-free rates.  Preference for companies with low ratings, including high yields. Bias floating bonds
  • Actions: tendency bullish market overweight. Business style “growth” small and medium cap stock positions exceeding 1 betas

During Peak phase:

  • Stagnation of GDP
  • Stagnant consumption: Mainly private
  • Maintenance of prices of goods and services (inflation)
  • Maintenance of wages, as well as purchasing powe
  • Stagnation of corporate profits
  • Increasing the marginal propensity to save
  • Maintenance of the unemployment rate
  • Confidence of consumers and producers decline

 Market behavior:

  • The currency tends to stay compared to other blocks
  • The monetary rates stuck at high rates
  • Public Debt: stuck in very high interest rates, flat curve, handbags and neutral short term
  • Per Private fja: Worsening credit quality was high yields, preferably by high ratings. bias towards fixed interest bonds
  • Actions: tendency bullish market overweight. Business style “growth” large and medium cap stock positions equal to 1 betas

During Recession Phase:

  • Fall in GDP
  • Contraction of consumption: Mainly private
  • Stagnation of prices of goods and services (inflation)
  • Wage growth below purchasing power
  • Business Benefits downward. Increased bankruptcies
  • Strong increase in saving
  • Increased unemployment
  • Confidence of consumers and producers decline

Bearish trend stock marketIn the graph it is represented the Bearish trend, where the stock prices keep decreasing. The ups are smaller than the downs in the long term…

 Market behavior:

  • The currency tends to depreciate against other blocks
  • The money market rates down to medium-low
  • Debt issues: lowering interest rates, sometimes very flat curve inverted, overweight long time
  • Per Private fja: Worsening credit quality bias towards high credit quality bonds
  • Actions: tendency bearish overall market. Securities companies refuge to “Blue-Chip” large capital positions below 1 beta values.

3.- Types of GDP and its appliances in the macroeconomic scenario

The Gross Domestic Product (GDP) it is the method that governments use to calculate the level of economic activity in the economy. It is the total value of goods and services produced in a certain region (country, state, city…) in a year.

There are a few variations of GDP calculations, depending on what to take into account as productive.

  • The Offer Method: Calculate the total production of all goods and services and deduce the inner consumption. For example, a car is the final good produced, but, it’s made out of thousands of different pieces, so the value of those pieces is discounted from the total value of the car.
  • Spending Method (Formula) =  C + PI + PE + ( X – I ) Here we calculate the private consumption (perishable and nonperishable goods, services… we do not take into account the acquisition of real estate here) + Private Investments (All investments done by private companies, and people excluding financial investments, in Real Estate ONLY includes NEW real estate acquisition, not second hand houses) + Public Expenditure (excluding monetary transfers as public benefits for unemployment or pensions), + (Exports – Imports).
  • Income Method: Consists in summing up all the incomes from factors that contribute to the productive process. (Salaries, rental income, commissions, artist rights, financial profits, public benefits, etc.)

The Spending Method is the most extended in use, due to the importance of taking into account the balance of trade with the difference between Imports and Exports.

Rate of change in GDP: It measures the increase or decrease in GDP from one year to another.

R%= ((GDPn – GDPn-1) / GDPn-1) · 100        n= Year “n”; “n-1”

GDP per capita: Total GDP of a region divided by the population of that region.

GDP/capita= GDP/N N= # of people

gross domestic product per capita

GDP Limitations as an indicator of the Economic Activity

  • GDP does not take into account the self-production, all produced for your own consumption. (Growing food in our garden, or domestic activities…)
  • The Black Market is usually introduced in the annual GDP calculation as an approximation. The average level of the tax evasion is around 10% of the GDP in the European Union, but some countries like Spain currently estimated around 25% of its economy being under this situation.
  • The service sector is very imprecise in its calculation because a change in price can be produced due to a change in quality of the service, or inflation.
  • In case of a natural disaster (hurricane, earthquake, tsunami…) the GDP indirectly accounts the destruction of the assets lost (roads, houses, factories…) through the calculation of “how the production will be affected”. So, not the total amount of goods destroyed, only the amount of production capacity that has been lost. On the other hand, the investments (usually public funded) to rebuild the damage it does count in the GDP.
  • GDP cannot measure other aspects of society as quality standards of life, and welfare. Only material.
  • Ecologic costs are not represented in the GDP. Nature is not considered an asset in that way.

Now that we know the basics, there is something a bit tricky that needs to be understood in order to move on with the course.

Ok, so, the GDP is the calculation of all goods and services produced in a certain region done by governments to know how their economies are doing. The way to calculate that, is by pricing the goods and services. So, if prices change it gets complicated to know how many goods and services are produced.

To eliminate the negative effect of the inflation in our calculation we use a year as a base to use prices of that year as prices for future calculations.

In the European Union the year we use now is 2008. It usually changes every decade. So, to know if economies are increasing their production, we now use the prices in 2008 and compare the amount of goods with those prices to how many goods and services are now being produced.

Simple example:

If in 2008: 100 cars produced at 10.000 €/car.  Total GDP= 1.000.000 € (inflation 2%)

So, in 2009: 100 cars produced at 10.200 €/car. Total GDP= 1.020.000€

Production has been the same but the calculation of the GDP it’s done with Real prices, and it gives us what we call, the REAL GDP. The real GDP it’s calculated with the current prices of the economy, but it is not useful, as we saw in the example above. So to be able to know the real production we would use the 2008 prices to get the NOMINAL GDP for 2009. We eliminate the effect of the inflation.

The GDP Deflator is an economic metric that measures inflation by converting output measured at current prices into constant-priced GDP. The GDP deflator shows how much a change in the base year’s GDP relies upon changes in the price level. Also known as the “GDP implicit price deflator.”

Deflator = (NominalGDP / RealGDP)

Because it isn’t based on a fixed basket of goods and services, the GDP deflator has an advantage over the Consumer Price Index. Changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator

The Output Gap is another metric of Economic activity. It is the difference between the Actual GDP and the Potential GDP (the 100% production of the economy).

4.- Price Development: Inflation and deflation

Inflation: generalized increase of prices in an economy.

  • Inflation is linked to the economic activity, at the end of the expansion period of the economic cycle prices go up. During recession prices usually decrease (depending how strong it hits the economy)
  • Central Banks are the ones in charge of controlling the inflation. Through the monetary policies central banks can stop inflation of getting too high, and more important, avoiding Deflation during recession periods where prices fall too much and too fast.

There are 2 common methods to calculate Inflation:

  • The Consumer Price Index: Basket of goods and services based on the patterns of consumption. A sample of common goods and services is taken to represent the whole market. It is literally impossible to account every good and service in the market and follow the development of all prices. Around 35 and 40 products are chosen as a sample of the market.
  • GDP Deflator:  Based on the development of all goods and services of the economy.

The Core Inflation is basically a Consumer Price Index of low volatile products. So into this calculation we would exclude all non-manufactured goods due to their seasonal condition and lack of stock (fresh food, fuels, raw materials…). This version of the calculation of the inflation it is used by central banks more than the regular calculation, because it is more constant and reliable.

stable prices inflation deflation
Deflation: It is the opposite effect on the economy than inflation.

  • It’s considered deflation when prices fall in a generalized way in the whole economy during two followed quarters or more.
  • The consequences of deflation are worse than a high inflation, due to:
  • Reduces the value of mortgages. (Credit is easier to return)
  • Changes the patterns of consumption; in the near future prices will be cheaper than today’s.
  • Very limited ways to attack that problem. Monetary policies with injection of credit in the market, and interest rates close to zero.
inflation table
In this graph it’s represented how different levels of inflation and deflation affect different to the financial assets, depending on their nature.

 

5.- Market expectations and Prediction of the Economic cycle

To be able to define the market expectations we are going to focus in 4 areas:

  • Consumers
  • Companies
  • Foreign Trade
  • Economic Policies

5.1. – Consumers:

  • Private consumption represents around the 55-60% of the GDP of the developed economies. This block of the GDP is not very volatile, because family consumption it is represented here. People need to eat and buy clothes during recession times too.
  • The factor that influences consumption is the level income (after taxes) of the population and its expectations for the future. If people believe they won’t have any income soon, usually stops consuming.

5.2. – Companies:

  • Private investment weights around 20% of the total GDP in developed economies. But it is very important due to its high volatility. If the expectations are bad the level of investment drastically drops.
  • It has an effect in the future, because it builds the future production.
  • The investments in fixed assets and current assets show the present and future activities of the companies.

5.3. – Foreign Trade:

To estimate the development of the foreign trade sector in an economy, it is important to take into account:

  • The exchange rate with the strongest currencies (either imports or exports)
  • Development of the Balance of Trade, the historical data from the last years.
  • Concentration of the flows of trade. Identify the biggest sectors in imports and exports.

5.4. – Economic Policies:

Monetary Policies: it is a branch of the Economic Policies, and it’s function is to control the amount of money that is in circulation to maintain the economic stability. It is decision of the Central Bank of each country (European Bank in all the EU) to adapt the monetary policy to each situation of the economy. When the central bank injects money into the economy it is called an expansive policy. On the other hand, when tries to reduce the amount of money in circulation it’s called a restrictive policy.
The basic Objectives of the Monetary Policy it is divided into 4 blocks:

  • Ensure the stability of the value of the money (prevent inflation)
  • Achieve the highest economic growth rate as possible.
  • Achieve the lowest unemployment rate as possible.
  • Avoid permanent disequilibrium in the balance of payments, maintain the exchange rate stable and protection of international monetary reserves (US Dollars, Euros, GB Pounds…)

Mechanisms of operation of the Monetary Policies:

  • Change in the interest rates
  • Open Market Operations: consist in the acquisition of some Bonds from the Central Bank to institutional Investors to give liquidity to the market
  • Cash reserve ratio (only affects Banks, it is the percentage of their total patrimony that needs to be saved as a reserve and can’t be invested. Recently this ratio has been risen in the EU after the bankruptcy situation of many European Banks

The Monetary Authorities have to look at variables like the Inflation, the excess of the production capacity and any other variables that show the trend of the economic cycle.
Taylor Rule: method to calculate when is it time for the Central Bank to change the nominal interest rate. The Taylor rule has been very criticized due to its variants. The most used formulae uses the variables of GDP and Inflation. (wikipedia has a very nice description of the rule and the Taylor principle)

Robj = DefGDP + [0.5 · (GDPN – GDPP) + 0.5 · (Inf – InfSD)]

DefGDP= Deflactor of the GDP expressed in “%”
GDPn= Nominal GDP
GDPP = Potential GDP  }  (GDPN – GDPP)= Output gap
Inf= Real Inflation
InfSD= Standard Deviation of Inflation based on the historic data (usually around 2 – 4 %)

5.5. – Fiscal Policy:

It is another branch of the Economic Policy that uses the public investment and taxation to ensure the economic stability. Some of the objectives that the Fiscal Policy has is to soften the changes in the economic cycle and maintain stability in the economy, with high employment rates and a healthy inflation rate.

  • Increasing public expenditure and lowering taxes are policies that stimulate the economy to grow
  • Decreasing public investment and rising taxes produces the opposite effect

It is important to take into account the level of indebtedness of the government. The internal limits signed with the senate in terms of public deficit. Some countries have agreed in setting up some limits in order to avoid bankruptcy. In the EU, all countries have been forced to sign those kind of agreements in order to receive economic aid from the European Fund.

monetary policy

These Graphs show how the interest rates are affected by the Monetary and Fiscal policies. The graph number 4 is the most worrying due to the inverted line that predicts lower risk in the future, but rough times for the present. So for a Government with that situation would be cheaper to ask for debt with a long term return rather than short term. When a loan for a 10 years period is cheaper than a 3 months it is clear that the country is in financial trouble.

6.- Economic Predictions based on juncture indicators

There are 3 different ways we can use to predict the development of the economy:

  • Econometric models
  • Advanced indicators
  • Checklists

6.1. – Econometric Models:

It is the most formal way to present some conclusions on the prediction of an economic result. The most used are Lineal Regression, Maximum Likelihood models and ARIMA (Autoregressive Integrated Moving Average). After optimization and using some historical data the parameters of the equation can be defined.

6.2. – Economic Indicators

An economic indicator is a statistical research made by financial institutions of any kind, to get information from the market. There are different kind of indicators, depending on the timing we divide them into 3 different groups. Advanced Indicators, coincident indicators and delayed indicators.
The Advanced Indicators are the ones that change before the market shows it. In this group we find:

  • Consumer Confidence (Michigan Index)
  • Business Confidence (ISM in the US, IFO in Germany)
  • Construction Licenses
  • Business Inventory
  • Differential between the Central bank interest rate and the 10 year bond
  • Tankan Report (Japan)

Coincident indicators show the changes in the economy at the time as they are happening.

  • Number of employees, non-farm Payrolls
  • Production industrial
  • Personal Income

Delayed indicators show the changes after they have happened. Their utility is to confirm the changes in the economic activity.

  • Unemployment duration rate (How long does it take to the unemployed to find a job)
  • Unemployment rate
  • Servicies Price Index

6.3.- Check list:

It is a method based on the improvement by learning from past errors. To read more about it click on the link https://en.wikipedia.org/wiki/Checklist

 

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