Reading 10 Capital market Expectations, Part 1: Framework and Macro Considerations

FinQuiz Notes – 2 0 2 1
1. INTRODUCTION

Capital market expectations (CME) (also known as

macro expectations) represent the investors’ Further, these formulated CME settings help investors in
expectations regarding the risk and return prospects of establishing the risk and return prospects of individual
broad asset classes. They help investors in formulating assets, and facilitate investors in security selection and
their strategic asset allocation, that is, in setting rational valuation.
return expectations on a long-term basis for the asset
classes of their portfolios.

2. Framework and Challenges

Long-run portfolio performance is primarily determined o Fixed Income: maturities, credit quality,
by asset allocation. Realistic long-run return projections fixed versus floating, nominal versus inflation
are crucial. For example, until the late 1990s, many protected etc.
institutional used to predict future returns by o Real Assets: real estate, commodities,
extrapolating historical returns. Inflated or unrealistic timber.
return projections may result in volatile (often
underfunded) obligations and unrealistic goal settings.
3. Specify the method(s) and/or model(s) to be used and
Now, majority of the institutions have chosen forward-
their information requirements. The analyst should clearly
looking methods to project returns.
specify and justify the method(s) and/or model(s) that
will be used to develop CME keeping in view the
Projecting accurate asset returns even using advanced
investment’s time horizon e.g. a discounted cashflow
methods is quite challenging. Therefore, the emphasis
method is most appropriate to use for developing long-
should not be on accuracy but on limiting the forecast
term equity market forecasts.
errors and ensuring cross-sectional consistency (internal
consistency across asset classes) and intertemporal
4. Determine the best sources for information needs. The
consistency (across various time horizons).
analysts/investors should search for the best and most
relevant sources for the information needed and should
A Framework for Developing Capital Market
2.1 be constantly aware of latest superior sources for their
Expectations
data needs; researching the quality of alternative data
sources, avoiding flowed data, using commercially
A framework for developing Capital market
available and reputable financial publications.
expectations has the following seven steps.
In addition, the analysts must select the appropriate
1. Specify the set of expectations needed, including the
data frequency e.g. long-term data series should be
time horizon(s) to which they apply. Analysts must
used for setting long-term expectations or evaluating
specify the explicit list of asset classes and investment
long-term volatility. In general:
horizons on which they need to develop capital market
expectations.
• For setting long-term CME, monthly, quarterly or
2. Research the historical record: For many forecasts, annual data series are useful.
historical data provide some useful information on the • For setting shorter-term CME, daily data series are
investment characteristics of the asset and factors that useful.
affect asset class returns. This step lays the foundation for 5th and 6th steps.

Analysts are required to divide the data into multiple 5. Interpret the current investment environment using the
dimensions such as: selected data and methods, applying experience and
judgement. The analysts should carefully apply set of
• Geographical area (e.g., global, regional, assumptions, compatible methodologies and judgement
domestic, nondomestic, individual countries); or to interpret steady forecasts across asset classes and
• Broad asset class (e.g. equity, fixed-income, or real over time horizons.
estate); or
• Sub-asset classes: 6. Provide the set of expectations needed, documenting
o Equities: styles, sizes, sectors, industries; conclusions. Analysts should document reasoning and
assumptions associated with their conclusions.
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Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

Transcription errors: Errors relating to gathering and

7. Monitor actual outcomes and compare them with recording of data are called transcription errors.
expectations, providing feed-back to improve the
expectations-setting process. This step involves Survivorship bias: Survivorship bias occurs when a data
monitoring and comparing actual outcomes against series reflects only data on surviving (or successful)
expected outcomes developed in step 6, to monitor entities. For example, hedge fund data are often subject
and review outcomes and to identify weaknesses in the to survivorship bias.
CME development process so that the expectations-
setting process or methods can be improved. Appraisal (smoothed) data. Infrequently traded and
illiquid assets (e.g. real estate, private equity etc.) do not
Three Characteristics of Good Forecasts. Good forecasts tend to have up-to-date market prices; rather, their
are: values need to be estimated, known as appraised
values. Appraised (smoothed) data represents less
i) unbiased, objective and well researched; volatile asset values. As a result, the correlations of such
ii) efficient (lesser forecast errors) assets with traditional assets (such as equities and fixed
iii) internally consistent (cross-sectionally and income) and risk (S.D.) of the assets are underestimated
intertemporally) or biased downward.

2.2.3) The Limitations of Historical Estimates

Practice: Example 1 Curriculum,
Reading 10. Though historical data is used to forecast future
outcomes, however, two primary challenges are
notable:
2.2 Challenges in Forecasting
i) historical data may not be good
2.2.1) Limitations of Economic Data predictors of future results.
ii) statistics from historical data may be poor
The data and assumptions used in the forecasting model estimate of desired metrics even when
must be error free. The challenges associated with historical data fairly represent the future.
forecasting include:
• Changes in regime: Risk/return characteristics of
• Time lag with which economic data are collected, asset classes may change as a result of changes in
processed, and disseminated. For example, the IMF technological, political, legal & regulatory
sometimes provides macroeconomic data for environments and disruptions i.e. war or natural
developing economies with a lag of two years or disaster. These shifts are called ‘changes in regime’,
more. The greater the time lag before information is which introduce the statistical problem of non-
reported (i.e. the older the data), the greater the risk stationarity (where different parts of a data series
that it provides irrelevant and uncertain information exhibit different underlying statistical properties).
about the present situation.
• Official revisions to initial data. Sometimes only recent A sensible approach for determining whether to
data points are revised. In some other cases all or use a particular data series answer the following
portion of the historical data series is revised called two questions:
‘benchmark revisions’.
• Definitions and calculation methods may change 1. Is there any reason to believe that selected
over time. This may affect the validity of time-series data series exhibit fundamental regime
data. change?
• Changes in the construction method of data. The 2. Do the data support the notion that the
bases of indices of economic and financial data are regime change has occurred?
changed on a periodic basis to reflect more current
bases. This process is known as re-basing. Re-basing If the answers to above questions are ‘Yes’, it
simply reflects a mathematical change rather than means there is a change in regime in the sample
substantive change in the composition of an index. period and the regime may change in future as
Re-basing may result in risk of mixing data indexed to well.
different base.
• Frequency of data: Generally, use of long-time
series data increases the precision of estimates
2.2.2) Data Measurement Errors and Biases and assure stationarity to some extent. Using high
frequency data improve the precision of sample
The errors and biases in data measurement include: variances, covariances and correlations but fail to
improve the precision of sample mean.
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

The higher the frequency of observations (weekly,

daily etc.), the higher the likelihood that data is
asynchronous (not concurrent in time) across Example:
variables and causes lead-lag relationships e.g.
issue of time-zone difference of daily data Suppose, an analyst is using CAPM to calculate
collected from various countries. unconditional expected return on an asset class.
• Beta of an asset class in economic expansion is
• Data are not normally distributed: The historical 0.80 and in economic recession 1.2
asset returns does not seem to be normally • Expected return on market during expansion is 12%
distributed and exhibit skewness and fat tails. and during recession is 4%
• Risk-free rate (both recession & expansion) is 2%

2.2.4) Ex Post Risk Can Be a Biased Measure of Ex Ante

Unconditional expected return calculation (using CAPM)
Risk
by:
In general, looking backwards ex ante risks are • Incorporating conditioning information
underestimated and ex ante returns are overestimated (approach 1)
because in looking back we underestimate the • Ignoring conditioning information (approach 2)
possibility of adverse event that did not materialize. This
phenomenon is referred to as “peso problem”. Approach 1- Incorporating conditioning information:
Expected return on market during:
The opposite situation i.e. ‘overstating the likelihood of o expansion = 2% + 0.80 (12% - 2%) = 10%
adverse event’ might also occur when only one such o recession = 2% + 1.20 (4% - 2%) = 4.4%
observation (rare event) included in the data series
substantially overestimate the likelihood of those adverse
Unconditional expected return on the asset class
events.
(weighting by probabilities) = 0.50 (10%) + 0.50 (4.4%) =
7.2%
2.2.5) Biases in Analysts’ Methods
Approach 2 - Ignoring conditioning information:
Data mining bias and time-period bias are among the
Unconditional beta = 0.50 (0.80) + 0.50 (1.2) = 1.0
preventable biases, analysts should consider for
Unconditional expected return on market = 0.50 (12%) +
developing improved capital market expectations.
0.5 (4%) = 8%

• Data-mining bias refers to over-using or Unconditional expected return on the asset class = 2% +
overanalyzing the same data (i.e. mining the 1.0 (8% - 2%) = 8%
data) until some statistically significant pattern is
found in the dataset. A sign that may indicate the Approach 2 is wrong as this approach does not take into
existence of data-mining bias is that there is no account the fact that asset class return varies with
plausible economic relationship among variables. business cycle (i.e. beta differs for expansion and
recession).
The data mining bias can be detected by
o providing economic rationale for the 2.2.7) Misinterpretation of Correlations
variable’s usability
o using out-of-sample data to test the A significant correlation between variable A and B
statistical significance of the patterns implies at least four possible explanations:
found in the dataset.

• Time-period bias occurs when outcomes are 1. A predicts B

2. B predicts A
time-period specific. For example, a short time
3. C (3rd variable) predicts A and B
series may give period-specific results that may
4. The relationship between A and B is spurious
not be reflected in a longer time period.

A thorough investigation is required before applying

2.2.6) The Failure to Account for Conditioning Information
correlations in a model.
Risk and return of an asset are conditional upon current A seemingly significant correlation can be spurious. On
as well as prospective economic and market the contrary, two variables may reflect weak or zero
environment. Estimates of expected risk and return correlation despite strong but non-linear relationship.
based on unconditional forecasts (which dilute
information by averaging) may generate erroneous 2.2.8) Psychological Biases
outcomes.
Psychological traps can undermine the analyst’s ability
to make accurate and unbiased forecasts. There is a
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

long list of phycological biases (under various names

and descriptions) that can affect investment decisions. This bias can be avoided by widening the range of
Some popular ones are given below: possibilities around the primary target forecast.

1. Anchoring bias: It is a tendency of people to give 5. Prudence bias: It is the tendency of analysts to be
undue emphasis to the initial information/values extremely cautious in forecasting in an attempt to
referred to as ‘anchor’, and then adjust their final avoid making any extreme forecasts which may
decisions up or down based on that “anchor” value. adversely impact their career.

To mitigate anchoring bias, analysts should avoid The prudence trap can be avoided by
making early judgements. incorporating plausible scenarios that may result in
more extreme results.
2. Status quo bias: It is a tendency of people to prefer
to “do nothing” by maintaining the “status quo” 6. Availability bias: It is the tendency to assign higher
instead of making a change. weight to more easily available and/or easily
recalled information e.g. information related to
• It is closely related with avoiding “error of catastrophic or dramatic past events, recent
commission” (regret from an action taken) and events etc.
making “error of omission” (regret from not taking
an action). This bias can be avoided by using objective data
and procedures in decision-making.
The status-quo bias can be overcome by following
a disciplined approach in decision-making.
Practice: Example 3 Curriculum,
Reading 10.
3. Confirmation bias: It is a tendency of people to
seek information that confirms their beliefs and
ignore or discount information that contradicts their 2.2.9) Model Uncertainty
beliefs. Confirmation bias implies assigning greater Investment analysis may be subject to three kinds of
weight to information that supports one’s beliefs. uncertainties:
This bias can be reduced or mitigated by: i) Model uncertainty- whether model is
structurally and/or conceptually correct.
This bias can be reduced or mitigated by: • potentially the most serious issue
• collecting and examining complete • as a result, analysts may draw
information fundamentally faulty conclusions
• actively looking for contradictory ii) Parameter uncertainty- whether model’s
information and contra-arguments. parameters are fitting.
• analysts should be careful about
4. Overconfidence bias: It is a bias in which people estimation errors.
demonstrate unwarranted faith in their own intuitive iii) Input uncertainty-whether inputs are correct.
reasoning, judgments, and/or abilities. • mostly occurs when using a proxy for
an unobservable variable.
• This bias may result in using too narrow • is critical when analyst’s focus is proof
range of possibilities or scenarios in of concept or theory
forecasting. • is less critical when analyst’s focus is
• Analysts with overconfidence bias are likely merely drawing valuable empirical
to ignore the possibility of uncertainties they relationships.
are aware “known unknowns” as well as
uncertainties they are unaware “unknown
unknowns”.

3. Economic and Market Analysis

This section illustrates the significance of economic and

market analysis in developing capital market Historically, there has been a correlation among actual
expectations. realized asset returns, expected future asset returns and
economic activity.
3.1 The Role of Economic Analysis
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

An analyst who has greater ability to predict a change • Natural disasters: Natural catastrophes destroy
in trend or point of inflection in economy activity and production capacity and shrink economic growth in
ability to identify economic variables relevant to the the short run. Overtime growth may increase if old
current economic environment is considered to have a systems are replaced by efficient ones.
competitive advantage. The inflection points are
indicators of both unique investment opportunities and • Natural resources/critical inputs: Discovery of new
source of latent risk. natural resources or improved methods to recover
them (through lower cost of production) may boost
Two major components of Economic Output: potential growth. On the other hand, persistent
supply shortage of resources shrinks growth.
• Trend Growth: It identifies the long-term
component of growth in an economy. It is • Financial crises: Financial shocks reduce economic
relevant for setting long-term return growth through decrease in bank lending and
expectations for asset classes. investor confidence, and consequently affect the
level of output and trend growth rate. Extensive
• Cyclical Variation: It measures short-term study of 2008 financial crises identified the following
fluctuations in an economy such as three types of financial crises with regards to the
corporate profits and interest rates etc. level of output and trend growth rate:

Exhibit: Trend Growth after a Financial Crises

3.2 Analysis of Economic Growth
Persistent Drop in Subsequent Trend
Economic Growth Trend: The long-term, average growth Level of output Rate of Growth
path of GDP around which the economy rotates (i.e. (permanent, one
slows down or grows) in response to business cycles. time drop)
Economic trend though related but is independent of Type 1 Yes Unchanged
business cycle. Type 2 No Reduced
Type 3 Yes Reduced
Trends are long-term averages whereas cycles are short-
term fluctuations. It is comparatively easy to forecast Post 2008, Eurozone experienced the Type 3
trends than cycles. financial crises.

Some trends are predictable especially those trends that

evolve slowly and are based on easily observable Practice: Example 4 Curriculum,
factors e.g. demographics. However, some trends such Reading 10.
as “exogenous shocks” are impossible to forecast.
3.2.2) Application of Growth Analysis to Capital Market
3.2.1) Exogenous Shocks to Growth Expectations

Shocks may originate from domestic or global sources. The expected trend rate of economic growth is
Some shocks may enhance potential growth while applicable in a variety of ways such as:
others may reduce it. Some major types of economic
shocks are given below:
• It is a key input in discounted cash flow
models of expected return.
• Policy change: Pro-growth government policies
• The higher the trend rate of economic growth
include sound fiscal policy, competition within
of a country, the more attractive returns are
private sector, minimal government interference in
private sector, sound tax reforms, reduction of trade for equity investors.
barriers, support for infrastructure and human capital • The higher the trend rate of economic growth
development etc. of a country, the faster an economy can
grow without any unsustainable increase in
inflation.
• New products and technologies: Technology,
• Level of real government bond yields and
innovations and new products plays a greater role in
improving potential growth. trend growth rate are interrelated.

• Geopolitics: Geopolitical conflicts (trade barriers, 3.2.2.1) A Decomposition of GPD Growth and Its Use in
using resources to acquire weapons, defense Forecasting
spending) reduce potential growth. Sometimes Trend growth in GDP:
geopolitical tensions encourage innovation and
introduce growth-enhancing technologies. • Growth from labor inputs
o growth in potential labor force size
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

o growth in actual labor force ii) long-run equity appreciations i.e. aggregate market
participation value of equity is a product of the following three
• Growth from labor productivity factors.
o growth from increasing capital inputs
o growth in total factor productivity Aggregate market value of equity 𝑉"# = 𝐺𝐷𝑃" × 𝑆"+ ×
(TFP). 𝑃𝐸"

Where,
𝐺𝐷𝑃 is a level of nominal GDP
𝑆"+ is the share of profits in the economy
𝑃𝐸" is the P/E ratio.

In the long run, growth rate of value of equity

(capital appreciation component) in an economy is
linked to the growth rate of GDP i.e. 𝑉"# → 𝐺𝐷𝑃" as the
other two factors cannot persistently increase or
decrease over long periods.

Forecasting stock market price changes – in short to

medium term can be achieved by analyzing
expected changes in P/E multiple and share of
Where, capital (in GDP).

• Labor inputs includes both number of workers Forecasting dividend yield can be achieved by
and average number of hours they work. dividing dividend payout ratio by profit multiple.
• Growth in the potential labor force size is
directed by demographics (e.g. population High economic growth rate does not necessarily
age distribution, net migration, workplace mean high equity market returns because: 1) 2)
norms etc.). Demographics usually tend to
change slowly but not always as the impact
of some structural changes is quick.
Practice: Example 5 Curriculum,
• Labor force participation indicates workers’
Reading 10.
‘labor versus leisure’ decisions. Factors that
affect labor force participation includes
social norms, rise/fall of real wages,
3.3 Approaches to Economic Forecasting
government policies, whether country is
getting richer etc.
• Growth from increasing capital inputs – Basic difference between Trend Growth & Econometric
investment in additional capital per worker Forecasting
called “capital deepening”.
• Total factor productivity (TFP) – captures Focuses on Attributed to
impacts from technological improvements, Trend growth rate long-term supply side of
increase in skilled labor, government average economy
regulations. Macroeconomic Primarily short- Primarily
forecasting to-intermediate demand side
Trend growth rate is considered to be relatively stable in term of economy
mature developed markets therefore extrapolating past fluctuations i.e. (shifts in
trends can be a reasonable initial estimate of the future (business aggregate
growth trend. Same approach with significant cycle) demand, but
adjustments to past trends is applied for less developed also to short-
markets. term
aggregate
3.2.2.2) Anchoring Asset Returns to Trend Growth supply curve)

Trend growth rate provides a baseline value for Following are the three economic forecasting
estimating: approaches:

i) bond yields over long horizons i.e. average level of i) Econometric models: the most formal and
real (nominal) bond yields is linked to trend rate of mathematical
real (nominal) growth. ii) Economic indicators: variables that lead, lag
or coincide with economic turns.
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

iii) Checklist approach: subjective economy’s recent past activity or its current or future
position in the business cycle.
These approaches are not mutually exclusive.
Types of Economic Indicators: Following are the three
types of economic indicators.
3.3.1) Econometric Modeling
Lagging economic indicator: indicators that reflect
recent past economic activity (i.e. change with some
Econometric models apply statistical methods
time lag with the change in the economy).
(comprising of equations) to model the relationships
among economic variables to forecast the future.
Coincident economic indicators: indicators that reflect
current economic activity (i.e. change simultaneously
o Structural models: analyze structural relationships
with the economy).
among variables based on economic theory.
Leading Economic Indicator (LEI): LEIs are indicators
o Reduced-form models: have less detailed
reflect future economic activity (i.e. change before the
knowledge. May range from simple compact
change in the economy) and therefore help to predict
form of underlying structural models to data
the future performance of economy. They are regarded
driven models with only a heuristic rationale for
as the most important type of economic indicators for
choice of variables.
analysts.
• Econometric models vary from small models to
LEI-based analysis:
complex models with hundreds of equations.
• Econometric models forecast future values of
• is the simplest forecasting approach because
economic variables (endogenous variable explained it involves only a limited number of variables
by the equation) while modeler supplies the • does not require analysts to make
exogenous variables (e.g. exchange rates, interest assumptions about the path of exogenous
rates, commodity prices) to the model. variables.

Strengths: Composite LEIs or Individual LEI index: Both individual

and composite LEIs are used in analysis. Composite LEIs is
• Econometric variable is useful for simulating the a collection of economic data releases that reflect an
effects of fluctuations in key variables. overall future performance of the economy.
• Econometric models restrict the forecaster to a
Diffusion index: Diffusion index is a measure that reflects
certain degree of consistency. number of upward trending indicators and downward
• Econometric models help modelers to reassess the trending indicators. E.g. if 8 out of 10 indicators are
views based on the model’s prior conclusion. exhibiting downward trend, it indicates that an
economy is likely to contract.
Limitations:
• Composite LEIs are subject to ‘look ahead
bias’ (relying on data that is not yet
• Econometric models require measures from the available) as entire history may be revised
real-world activities and relationships, data on each month.
which may not be easily available. • LEIs are considered to be less effective in
• Variables in the models may be measured with assessing the outlook of an economy.
error.
• The model may have faulty assumptions 3.3.3) Checklist Approach
• Relationships may be wrongly specified due to
This method involves subjective integration of a range of
structural changes in the economy overtime. economic data. The information gathered can be
extrapolated into forecasts in two ways i.e. objective
Therefore, modelers are required to incorporate past statistical methods (i.e. time series analysis) or subjective
forecast errors into the model and conduct careful or judgmental means to assess the outlook for the
economy.
analysis of output.
Strengths:
3.3.2) Economic Indicators
• It is a simple and straightforward method.
Economic indicators are economic statistics provided by
government and established private organizations on an • It provides flexibility as the forecaster is allowed to
quickly incorporate structural changes in the
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

economy by changing the variables or the weights Reference: CFA Institute’s Program Curriculum, Reading
assigned to variables within the analysis. 10, Exhibit 4.

Practice: Example 6 Curriculum,

Reading 10.
Limitations:
3.4 Business Cycle Analysis
• It is time-consuming because it requires analysis of
broad range of data. Trend rate of economic growth identifies long-term
• It depends on subjective judgment. return expectations for asset classes.

Business cycle analysis stipulates short-term fluctuations in

3.3.4) Economic Forecasting Approaches: Summary of
an economy. These cyclical variations may vary in
Strengths & Weaknesses
duration and intensity (from few days to very long
horizons i.e. decades)) and may contain many
intermediate frequency cycles.
Econometric Models Approach
Strengths Weaknesses The business cycle arises due to uncertainties in the
• models can be quite • complex & time economy, expectational errors and incompetence to
robust and may provide consuming adjust rapidly to unexpected events; hence, they are
forecasts close to reality. • inputs not easy to difficult to forecast.
• can be modified readily forecast
to accommodate • model may be mis- Sources of uncertainties may be exogenous or
changing conditions. specified endogenous to the system.
• imposes discipline/ • may give false sense
consistency on analysis. of precision Endogenous uncertainties include behaviors of
• provide quantitative • rarely forecast competitors, suppliers, employers, creditors, customers
estimates of the effects of turning points and policy makers; price-quantity adjustments.
changes in exogenous
variables on the Exogenous uncertainties include technological
economy. developments, political & geopolitical shifts, weather
patterns, major shocks, natural disasters etc.

Leading Indicator – Based Approach The business cycle can be monitored using the following
Strengths Weaknesses variables:
• intuitive • History subject to
• simple in construction frequent revision • GDP growth
• focuses primarily on • Current data not • Industrial production (IP)
identifying turning points reliable as input for • Employment/unemployment
• may be available from 3rd historical analysis • Purchasing manager indexes
parties • Overfitted in-sample • Orders for Durable goods
• easy to track • Can provide false • Output gap (difference between potential GDP
signals and actual GDP)
• May provide little • Leading indicator indexes
more than binary
guidance
3.4.1) Phases of Business Cycle
Checklist Approach
Strengths Weaknesses Phases of business cycles can be described by various
• limited complexity • subjective manners.
• flexible • time-consuming
o to incorporate • manual process limits Two phase segmentation of the business cycle:
structural changes depth of analysis One primary (and fairly easy to identify) segmentation of
o to add/drop items • may allow
the business cycle is “the expansion and the
o to draw information inconsistent &/or
from various sources biased views, contraction” with key turning points at which growth
• breadth (can include any theories, changes signs are the peak and the trough respectively.
topics, perspectives, assumptions.
theories, assumptions). Five phase segmentation of the business cycle:
 Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

A finer subdivision of a typical business cycle (for the • stock markets trend upward
purpose of setting expectations for capital markets)
comprised of the following five phases.
3. Late Expansion
During this phase, an economy tends to grow rapidly
and is likely to be overheated and face inflationary
pressures due to closing of output gap.

1. Initial Recovery:
Characteristics:
In this phase, the economy starts to grow from its
slowdown or trough part of the cycle. This is a short
phase that usually lasts for few months. • output gap has closed
• economy is exposed to overheating
Characteristics: • low unemployment
• strong profits
• rise in inflation, wages and investment spending
• economy picks up
• debt coverage ratio may deteriorate as balance
• business confidence starts to increase
sheets expand and interest rates rise.
• monetary policy is still stimulatory
• output gap is still large central bank may aim for soft landing as fiscal balances
• inflation is decelerating improves
• improvement in spending on houses and
consumer durables Capital Market Effects:

Capital Market Effects: • interest rates tend to rise due to restrictive

monetary policy;
• bond yields also tend to rise however, yield curve
• short-term rates and Government bond yields
continues to flatten.
continue to fall in expectation of falling inflation,
• stock markets may rise but it is highly volatile.
and then start bottoming;
• cyclical assets underperform and inflation hedges
• stock markets may rise briskly (as fears of recession
(e.g. commodities) outperform.
fade away);
• attractive investments include cyclical assets and
riskier assets i.e. small stocks higher-yield corporate 4. Slowdown:
bonds, emerging market equities & bonds. The economy starts slowing down primarily due to rising
interest rates. During this phase, an economy is highly in
danger of going into recession.
2. Early Expansion
During this phase, the economy starts gaining
Characteristics:
momentum.

Characteristics: • the economy approaches its peak and starts

slowing
• confidence among businesses starts falling;
• the economy gains some momentum
• inflation is still rising despite slowdown in growth
• unemployment starts to fall
mainly due to increase in prices by businesses.
• output gap is still negative
• consumers borrow and spend
• business increase production and investment Capital Market Effects:
• profits rise rapidly
• strong demand for housing and consumer durables • short-term interest rates are high & rising but, after
reaching some peak point, they start falling →
Capital Market Effects: indicating inverted yield curve;
• as the yields fall afterwards, bonds prices rally
sharply;
• short-term interest rates trend upward; longer-term
• credit spreads widen
bond yields may be stable or increase slightly; as a
result, yield curve is flattening
 Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

• stock market may fall, however, quality stocks and

interest-sensitive stocks (such as utilities) may 3.4.3) Inflation and Deflation: Trends and Relation to the
perform well. Business Cycle

Typically, central bank’s policy tools are more effective

5. Contraction:
in decelerating economic activity than in accelerating
Recession typically lasts for 12 to 18 months.
the economic activity.

Characteristics:
Deflation negatively affects the economy in two ways.
Deflation tends to:
• investment spending typically leads to contraction.
• business cut production and profits drop sharply
• reduce the value of debt-financed investments
• unemployment rises
• undermine central bank’s ability to affect
• credit tightens
monetary policy to control the economy. (as
• often associated with major bankruptcies, incidents
interest rates are close to zero therefore central
of uncovered fraud, or a financial crisis;
bank is unable to stimulate the economy with
• central bank ease monetary policy
monetary policy).

Capital Market Effects:

Inflation is procyclical and tends to:

• both Short-term interest rates & longer-term bond

• increase during late stages of a business cycle
yields start falling;
when there is no output gap which puts upward
• yield curve steepens significantly pressure on prices.
• in the early stages, stock market declines • fall during recessions and the early stages of
• in the later stages of the recession, stock market recovery when there is a large output gap which
starts to improve puts downward pressure on prices.
• credit spread widens until signs of trough emerges
Similar to inflation, inflation expectations are also
procyclical. However, with regards to timeframe
3.4.2) Market Expectations and the Business Cycle
(provided investors maintain confidence in the central
bank’s target):
It is quite difficult to identify the current phase of the
cycle and correctly predict the starting time of the next
phase because: • very long-term inflation expectations are
unaffected by periodic fluctuations.
• short-term inflation expectations turn up with
• the phases of the business cycle vary substantially
actual inflation.
in length (duration) and amplitude (intensity): for
• intermediate-term inflation expectations
example,
interweave with different phases of cycles.
o recessions can be steep with a huge decline
in output and a substantial rise in
Therefore, horizon structure of inflation expectation is
unemployment; or it can be short lived with
countercyclical i.e. upward sloping during contraction
only a small decline in output and only a
phase and downward sloping during expansion phase.
modest rise in unemployment.
o weak phase of the business cycle may
Effect of Inflation on Asset Classes
involve only a slower economic growth or a
“growth recession” rather than a recession.
1. Cash:
• it is difficult to distinguish between cyclical forces
and secular forces playing on the economy and • means short-term interest-bearing instrument,
the markets. not currency or zero-interest deposit.
• the connection between real economy and • functions as zero-duration, inflation protected
capital market returns is quite uncertain. s asset (i.e. earns floating real rate) considering
short-term interest rates adjust with expected
inflation.
Practice: Example 7 Curriculum, • is attractive(unattractive) in rising(declining)
Reading 10.
rate environment.
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

• is attractive investment in deflationary items when needed. 2) As supply is not a problem

environment. (assumption 1 above) – business cycles are caused by
changes in demand – too high or too low demand
creates imbalances.
2. Bonds:
• When inflation ↑(↓), nominal bond price ↓(↑); These two assumptions imply direct relationship between
holding bonds incur capital losses(gains). prices and production of goods and services. At higher
• When inflation remains within expected prices (which is because of higher demand) more goods
cyclical range, short-term yields rise/fall more and services are produced, and economy overheats.
than long-term yield (but have less price Thus inflation is pro-cyclical.
impact due to shorter duration.).
• When inflation moves out of the expected Sometimes inflation is caused by supply shock. This will
range, longer-term yields may rise/fall more lead to higher prices AND low production, known as
sharply than short-term yields. stagflation. Inflation will be countercyclical in such
• Persistent deflation favors high quality bonds situation (inverse relation between inflation and
and damages the creditworthiness of lower- production). This situation is assumed to arise very rarely
quality debt. in future.

3. Stocks:
Practice: Example 8 Curriculum,
• When inflation remains within expected Reading 10.
range, neutral effect on stocks as both
expected future cashflows (earnings +
dividends) and discount rates change in line 3.5 Analysis of Monetary and Fiscal Policy
with the horizon structure.
• Unexpected rise in inflation is negative for Monetary Policy:
financial assets. Less negative for companies Central banks use monetary policy (primarily interest
or industries able to pass on inflated costs. rates) as a tool to intervene in the business cycle to
• Deflation negatively affect asset-intensive, manage the cyclical behavior of the economy and to
commodity-producing and highly levered prevent it from either overheating or suffering from a
companies. recession for too long. Therefore, the purpose of
monetary policy is to be countercyclical.
4. Real estate:
Each central bank sets its own mandate and objectives;
• When inflation remains within expected range
and selects its own mix of tools (policy rates, liquidity
→ rental income rises with expected inflation etc.).
and asset values remain stable.
• Unexpected rise in inflation, ↑ demand for real Drawbacks of Monetary Policy
estate, as a result rental income ↑ faster than Central bank’s capacity to regulate the economy is
inflation and asset values ↑. limited amid substantial uncertainty as well as long and
• Unexpected fall in inflation (or deflation) puts variable time lags. Thus, there are risks that central
banks’ actions may create more economic instability
downward pressure on expected rental
instead of resolving the issue.
income and asset prices (particularly for less
than prime properties). Central bank’s monetary policy can be like pulling or
• Note: The impact on real estate rental pushing on a string. Pulling(pushing) on a string is similar
income (cashflows) and adjustments to restrictive(expansionary) monetary policy.
depends on the length of lease, existing
supply of similar properties, type of real estate Fiscal Policy:
asset held. Fiscal policy influences the economy by adjusting
government spending and taxation.
Important Note: Above discussion is based on TWO
Fiscal policy focus is NOT on short term growth because:
assumptions. 1) Supply is available without any problem
1) Implementation delay 2) frequent changes will be
(i.e. as demand grows, supply of goods and services will problematic for supplying dependable government
be available – though at slightly higher prices). This services.
means that either there is unutilized capacity in the
economy and/or that globalization allows importing
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

Exception to above: Automatic fiscal stabilizers After 2007-2009 financial crisis (due to the above-
(progressive tax (a pro-cyclical measure) and means- mentioned reasons) central banks sought some
based transfer payments (a counter-cyclical measure)) unconventional measures.
work as breaks on rising and as cushion for falling
economy. One such measure was QE (quantitative easing) in which
central banks purchased high-quality government
Except for a major structural change in fiscal stance, securities at a large scale. This action boosted banks’
following applies: excess reserves and lowered sovereign bond yields. QE
was widely used by many central banks such as the US
To establish Primary Focus Secondary Federal Reserve, the European central bank, the Bank of
market Focus Japan and the Bank of England.
expectations for
Short-term Monetary Fiscal Ideally, the execution of QE should have attained the
Long-term Fiscal Monetary desired level of economic growth through spending as
displayed in the exhibit below.

3.5.1) Monetary Policy

Taylor Rule relates a central bank’s target short-term

interest rate to the rate of growth of the economy and
inflation.

Taylor Rule Equation:

:2 - Y
i∗ = r1234567 + π2 + 0.5 × (Y : 4521; )+ 0.5 × (π2 – π465=24 )

where,
𝑖 ∗ = target nominal policy rate
rneutral = real policy rate that would be targeted if GDP
growth were on trend and inflation on target
π2 , π465=24 = respectively the expected and target
inflation rates
: : 4521; = respectively the expected and trend real
Y2 , Y
GDP growth rates
By readjusting the above equation:

Real inflation adjusted target rate =

:2 − Y
i∗ − π2 = r1234567 + 0.5 × (Y : 4521; )+ 0.5 × (π2 – π465=24 )

Monetary policy in unlikely to be determined by a single

equation as many judgments will be involved in
estimating inputs.
In reality, as a result of QE, though asset prices rose but
Practice: Example 9 Curriculum, businesses borrowed to fund dividends and stock
Reading 10. buyback instead of capital expenditure and individuals’
spending ability remained significantly lower because of
2007 financial crisis.
3.5.2) What Happens When Interest Rates Are Zero or
Negative? Benefit of use of QE and negative interest rates is still
debatable. However, negative rates didn’t result in
Prior to 2007-2009 financial crisis, it was assumed that feared negative consequences.
zero lower bound (when rates are close to zero) would
limit central bank’s ability to stimulate growth. Households and business continued to use bank services
Individuals’ preference to hold currency (when facing (did not hoard cash) – even in presence of negative
negative interest rates) would lower bank’s reserves and interest rates. This happened as modern economy
deposits causing credit contraction. The contraction of requires transactions with large size and large frequency;
credit would further put upward pressure on interest cash cannot serve this purpose.
rates leading to slow down in economic growth which
would in turn require additional stimulative policies. In theory, negative rates should stimulate economy in
the same manner as low but positive rates.
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

Changes in monetary policy appears to be more

effective in stimulating/countering economic growth in Key considerations when forming capital market
high interest rate environment – compared to expectations in a negative interest rate environment
low/negative rate situations.
i) Historical Data are less likely to be reliable because:
• of fundamental and structural changes in
3.5.3) Implications of Negative Interest Rates for Capital markets and the economy.
market Expectations • information about historical data rarely includes
situations of negative rates.
When interest rates are negative, in forming capital • of quantitative (especially statistical) models’
market expectations for: discrepancies. Additionally, forecasting must
account for differences in current and historical
i) longer time horizons, values.
• ‘long-term equilibrium short-term rate’ is used as
a baseline rate in models. This rate is estimated ii) Effects of other monetary policy measures appearing
using Taylor rule’s r1234567 rate. simultaneously

ii) shorter time horizons, Note:

• ‘expected path of interest rates’ (possible Developing capital market expectation in negative
scenarios weighted by probability) should be interest rates is challenging because asset prices are not
considered. The path starts from negative only determined by investor expectations regarding
interest rates values and usually converge to the long-term equilibrium levels but also on how to reach
long-run equilibrium rate estimate. those levels.

Asset class returns amid negative interest rate 3.5.4) The Monetary and Fiscal Policy Mix
expectations are similar to returns in contraction and The mix of fiscal and monetary policies affect the:
early recovery phases of a normal business cycle. • level of interest rates
However, compared to the normal business cycle • shape of the yield curve
phases, in negative interest rate environment there may • relative supply of government bonds of
be severe economic distress and greater uncertainty various maturities
regarding timing and strength of economic outlook.
i) Level of Interest Rates:

Effect of Persistent Policy Mix on the Average Level of Rates

Fiscal Policy Monetary Policy Nominal

Rates
Loose ⇒↑ Real Rates + Loose⇒↑ Expected = ↑
Inflation
Tight ⇒↓ Real Rates + Tight ⇒↓ Expected = ↓
Inflation
Loose ⇒↑ Real Rates + Tight ⇒↓ Expected = Mid
Inflation
Tight ⇒↓ Real Rates + Loose⇒↑ Expected = Mid
Inflation

As represented in the table above, all else equal: ii) Slope of the Yield Curve
The slope of the yield curve mainly depends on:
• loose fiscal policies increase levels of real • expected future path of short-term rates
rates as households and private businesses • risk premium (inherent in longer maturity
save more/invest and attract foreign capital. bonds)s
• persistently loose (tight) monetary policies
results in higher(lower) actual and expected Note:
inflation. Risk premium justifies why rates are typically upward
• the combined impact of loose and tight sloping whereas flattening or steepening of the yield
policies could be resulted in higher or lower curve is affected by expected future path of short-term
nominal rates and are labelled as mid-levels. rates which are mainly driven by business cycles and
policies.
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

Initial Recovery Early Expansion Late Expansion Slowdown Contraction

Monetary • stimulative • dropping • becoming • tight • increasingly
Policy & stance stimulus restrictive • tax revenue more
Automatic • moving may ↑ stimulative
Stabilizers towards
tightening
Money • low/ • rise and speed • above • approaching • declining
Market Rates bottoming up average & peak
• expected to rising
rise over • expectations
progressively may be
shorter moderated by
horizons eventual peak
/ decline
Bond Yields & • long rates • yields ↑ • yields rise at • yields peak, • yields
the Yield bottoming • stable at slow pace then may declining
Curve • shortest rates longer • curve decline • curve
start to ↑. maturities flattening from sharply steepening.
• Curve is steep • yield curve’s 1st longest • curve flat to • steepest at
half maturities inverted the tip of
⇒steepening, inward initial
last half recovery
⇒flattening phase

Reference: CFA Institute’s Program Curriculum, Reading 10, Exhibit 6

iii) “The relative supply of government bonds at various 3.5.5) The Shape of the Yield Curve and the Business
maturities” is the third factor, the importance of which Cycle
has become crucial after 2008-2009 financial crisis
mainly due to the following two reasons. The shape of the yield curve is useful to predict
economic growth and the economy’s position in the
• No clear lower bound on nominal interest rates business cycle.
• Persistent large government deficits due to
massive quantitative easing by central banks. If As mentioned in the exhibit above, yield curve flattens
the relative supply of debt along the yield curve during the expansion phase, at the peak it is completely
matters, then the shape of the yield curve and flat or even inverted and then steepens at the bottom of
financial markets will be affected by how in the cycle.
future governments will fund their deficits and
central banks will manage the maturity of their The curvature of the yield curve is primarily determined
holdings. by the expected future path of the short-term rates.
Analyzing the curve can give us information about
Issue of bonds in large quantity for a specific maturity market participants perception of future changes in
(e.g. 5y) by the government can cause a temporary short-term interest rates.
increase in yield for that particular maturity. The impact
disappears over time as investors move up or down the Analysts need to be careful as shape of yield curve at T0
yield curve to exploit yield differences. may predict economic growth in T1 and economic
growth in T1 may predict shape of yield curve at T2.
Very-long-maturity bonds are an exception to the
above-mentioned paragraph.
Practice: Example 10 Curriculum,
Keeping rates very low in huge-and-rising government Reading 10.
debt environment can be politically attractive for
governments (this may happen if central banks is not
independent). This can have two impacts:
A. Risk that B. (below) happens will cause yield 3.6 International Interactions
curve to steepen.
B. Inflation spiral may happen (i.e. higher inflation Currently, the significance of international interactions
à higher nominal rates à more fiscal deficit à for an economy has increased due to the increase in
more government debt à central bank forced globalization of trade, capital flows and direct
to run more accommodative monetary policy investments.
à more inflation)
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

A country’s international interactions depend on the

country’s: Current account changes are slow to occur and reflect
o relative size secular trend.
o degree of specialization
When a country is running huge current account
Compared to smaller economies, large and diverse imbalance (e.g. deficit); capital account should
countries are less influenced by developments in other generate surplus to bring balance back. This can be
economies. achieved by quick change in 1) exchange rate 2)
interest rate 3) financial asset prices. (e.g. higher interest
rates, currency devaluation and low financial asset
3.6.1) Macroeconomic Linkages prices will attract foreign investors and generate surplus
Current and capital account levels signify the in capital account)
macroeconomic linkages between two countries.
Practice: Example 11 Curriculum,
1. Current account represents: Reading 10.

• Net exports of goods and services

3.6.2) Interest Rate/Exchange Rate Linkages
• Net investment income flows
• Unilateral transfers
The link between interest rates and exchange rates is
crucial for investors. A country can achieve at maximum
2. Capital account (financial account) represents:
only two of the following:
• Net investment flows for foreign direct
investment (FDI) - buying/selling of productive
• free movement of capital
assets across borders
• fixed exchange rate
• Portfolio Investment flows (PI) involving
• independent monetary policy
transactions in financial assets

Why? When a central bank pushes interest rate Down

Current and capital accounts are counterparts. Any
(loose monetary policy)à investors will flee from capital
surplus (deficit) in one account is matched and
markets (no one likes low returns when they can get
cancelled by equal deficit (surplus) in the other
better return somewhere else – assuming same risk) à
account.
exchange rates will decline à central bank will have to
buy its own currency à low capital availability will push
Net exports (the component of current account) is
interest rates back UP (offsetting earlier loose monetary
considered to be the most important element that links a
policy).
country’s current and capital accounts to the broader
economy and contribute directly to the aggregate
If currencies of two countries are pegged, assuming
demand for the country’s output.
perfect capital mobility and fixed exchange rates à
countries should have equivalent interest rates.
According to National Income accounting,
We can extend this rationale to yield curve.
Net exports = Net Private Savings + Government Surplus
(X–M) = (S–I) + (T-G)
Two countries share a yield curve when:
Net private savings = Domestic private Savings –
Investment spending • perfect capital mobility (to balance risk-
Government Surplus = Taxes – Government spending adjusted capital returns)
• credibly fixed exchange rates (forever)
If investors believe that the exchange rates
Four primary tools used to balance the current and will change in future, the risk-return
capital accounts are: expectations will change and both countries
would no longer share the same yield curve.
i) changes in income (GDP)
ii) Relative prices If exchange rates between two countries are not
iii) Interest rates credible fixed, then the bond yields of weaker currency
iv) Asset prices will almost always be higher. However, in the event of
imminent threat of devaluation, the yields of devaluing
currency declines sharply and yield curve inversion
These tools are used to adjust the real economy (current
happens (spreads widen more at shorter maturities).
account and FDI) and financial markets. However,
investment markets adjust more quickly than the real
economy.
Reading 10 Capital Market Expectations, Part 1: Framework and Macro Considerations FinQuiz.com

When exchange rates float freely, the link between Investors care about:
interest rates and exchange rates is primarily
expectational. • domestic asset’s real return.
• non-domestic asset’s nominal returns and
If a country’s currency is expected to depreciate exchange rate change.
(appreciate), its bond yields will tend to rise (fall) to
balance risk-adjusted expected return.
“Global savings must always equal global investments”
on the basis of which real interest rates across countries
Note:
are linked. Capital flows towards more productive usage
Capital mobility alone is insufficient factor to adjust bond
and excess savings in one country lead to excess
yields across two countries.
investments in another country.

Practice: End of Chapter Questions

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