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Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

11 Macroeconomic and Industry Analysis

The unemployment rate is the percentage of the total labor force (i.e., those who are either unemployment
working or actively seeking employment) yet to find work. The unemployment rate measures rate
the extent to which the economy is operating at full capacity. The unemployment rate is a sta- The ratio of the
tistic related to workers only, but further insight into the strength of the economy can be number of people
gleaned from the employment rate of other factors of production. Analysts also look at the factory classified as
unemployed to the
capacity utilization rate, which is the ratio of actual output from factories to potential output.
total labor force.

Inflation is the rate at which the general level of prices is rising. High rates of inflation often
are associated with “overheated” economies, that is, economies where the demand for goods The rate at which the
and services is outstripping productive capacity, which leads to upward pressure on prices. general level of
Most governments walk a fine line in their economic policies. They hope to stimulate their prices for goods and
services is rising.
economies enough to maintain nearly full employment, but not so much as to bring on infla-
tionary pressures. The perceived trade-off between inflation and unemployment is at the heart
of many macroeconomic policy disputes. There is considerable room for disagreement as to
the relative costs of these policies as well as the economy™s relative vulnerability to these pres-
sures at any particular time.

Interest Rates
High interest rates reduce the present value of future cash flows, thereby reducing the attrac-
tiveness of investment opportunities. For this reason, real interest rates are key determinants
of business investment expenditures. Demand for housing and high-priced consumer durables
such as automobiles, which are commonly financed, also is highly sensitive to interest rates
because interest rates affect interest payments. In Section 11.3 we will examine the determi-
nants of real interest rates.

Budget Deficit
The budget deficit of the federal government is the difference between government spending budget deficit
and revenues. Any budgetary shortfall must be offset by government borrowing. Large amounts The amount by which
of government borrowing can force up interest rates by increasing the total demand for credit in government spending
the economy. Economists generally believe excessive government borrowing will “crowd out” exceeds government
private borrowing and investing by forcing up interest rates and choking off business investment.

Consumers™ and producers™ optimism or pessimism concerning the economy are important de-
terminants of economic performance. If consumers have confidence in their future income
levels, for example, they will be more willing to spend on big-ticket items. Similarly, busi-
nesses will increase production and inventory levels if they anticipate higher demand for their
products. In this way, beliefs influence how much consumption and investment will be pur-
sued and affect the aggregate demand for goods and services.

1. Consider an economy where the dominant industry is automobile production for Concept
domestic consumption as well as export. Now suppose the auto market is hurt by
an increase in the length of time people use their cars before replacing them. De-
scribe the probable effects of this change on (a) GDP (b) unemployment, (c) the
government budget deficit, and (d) interest rates.
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

386 Part FOUR Security Analysis

The level of interest rates is perhaps the most important macroeconomic factor to consider in
one™s investment analysis. Forecasts of interest rates directly affect the forecast of returns in
the fixed-income market. If your expectation is that rates will increase by more than the con-
sensus view, you will want to shy away from longer term fixed-income securities. Similarly,
increases in interest rates tend to be bad news for the stock market. Unanticipated increases in
rates generally are associated with stock market declines. Thus, a superior technique to fore-
cast rates would be of immense value to an investor attempting to determine the best asset al-
location for his or her portfolio.
Unfortunately, forecasting interest rates is one of the most notoriously difficult parts of ap-
plied macroeconomics. Nonetheless, we do have a good understanding of the fundamental
factors that determine the level of interest rates:
1. The supply of funds from savers, primarily households.
2. The demand for funds from businesses to be used to finance physical investments in
plant, equipment, and inventories.
3. The government™s net supply and/or demand for funds as modified by actions of the
Federal Reserve Bank.
4. The expected rate of inflation.
Although there are many different interest rates economywide (as many as there are types of
securities), these rates tend to move together, so economists frequently talk as though there
were a single representative rate. We can use this abstraction to gain some insights into deter-
mining the real rate of interest if we consider the supply and demand curves for funds.
Figure 11.3 shows a downward-sloping demand curve and an upward-sloping supply
curve. On the horizontal axis, we measure the quantity of funds, and on the vertical axis, we
measure the real rate of interest.
The supply curve slopes up from left to right because the higher the real interest rate, the
greater the supply of household savings. The assumption is that at higher real interest rates,
households will choose to postpone some current consumption and set aside or invest more of
their disposable income for future use.
The demand curve slopes down from left to right because the lower the real interest rate,
the more businesses will want to invest in physical capital. Assuming that businesses rank
projects by the expected real return on invested capital, firms will undertake more projects the
lower the real interest rate on the funds needed to finance those projects.

F I G U R E 11.3 Interest rate
Determination of the
equilibrium real rate of

real rate
of interest

Equilibrium funds lent
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

11 Macroeconomic and Industry Analysis

Equilibrium is at the point of intersection of the supply and demand curves, point E in
Figure 11.3.
The government and the central bank (the Federal Reserve) can shift these supply and de-
mand curves either to the right or to the left through fiscal and monetary policies. For exam-
ple, consider an increase in the government™s budget deficit. This increases the government™s
borrowing demand and shifts the demand curve to the right, which causes the equilibrium real
interest rate to rise to point E ™. That is, a forecast that indicates higher than previously ex-
pected government borrowing increases expectations of future interest rates. The Fed can off-
set such a rise through an increase in the money supply, which will increase the supply of
loanable funds, and shift the supply curve to the right.
Thus, while the fundamental determinants of the real interest rate are the propensity of
households to save and the expected productivity (or we could say profitability) of firms™ in-
vestment in physical capital, the real rate can be affected as well by government fiscal and
monetary policies.
The supply and demand framework illustrated in Figure 11.3 is a reasonable first approxi-
mation to the determination of the real interest rate. To obtain the nominal interest rate, one
needs to add the expected inflation rate to the equilibrium real rate. As we discussed in Sec-
tion 5.4, the inflation premium is necessary for investors to maintain a given real rate of return
on their investments.
While monetary policy can clearly affect nominal interest rates, there is considerable con-
troversy concerning its ability to affect real rates. There is widespread agreement that, in the
long run, the ultimate impact of an increase in the money supply is an increase in prices with
no permanent impact on real economic activity. A rapid rate of growth in the money supply,
therefore, ultimately would result in a correspondingly high inflation rate and nominal inter-
est rate, but it would have no sustained impact on the real interest rate. However, in the shorter
run, changes in the money supply may well have an effect on the real interest rate.

A useful way to organize your analysis of the factors that might influence the macroeconomy
is to classify any impact as a supply or demand shock. A demand shock is an event that af- demand shock
fects the demand for goods and services in the economy. Examples of positive demand shocks An event that affects
are reductions in tax rates, increases in the money supply, increases in government spending, the demand for goods
or increases in foreign export demand. A supply shock is an event that influences production and services in the
capacity and costs. Examples of supply shocks are changes in the price of imported oil;
freezes, floods, or droughts that might destroy large quantities of agricultural crops; changes
supply shock
in the educational level of an economy™s workforce; or changes in the wage rates at which the
labor force is willing to work. An event that
Demand shocks usually are characterized by aggregate output moving in the same direc- influences production
capacity and costs in
tion as interest rates and inflation. For example, a big increase in government spending will
the economy.
tend to stimulate the economy and increase GDP. It also might increase interest rates by in-
creasing the demand for borrowed funds by the government as well as by businesses that
might desire to borrow to finance new ventures. Finally, it could increase the inflation rate if
the demand for goods and services is raised to a level at or beyond the total productive capac-
ity of the economy.
Supply shocks usually are characterized by aggregate output moving in the opposite direc-
tion as inflation and interest rates. For example, a big increase in the price of imported oil will
be inflationary because costs of production will rise, which eventually will lead to increases
in prices of finished goods. The increase in inflation rates over the near term can lead to higher
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003
Fifth Edition

388 Part FOUR Security Analysis

nominal interest rates. Against this background, aggregate output will be falling. With raw ma-
terials more expensive, the productive capacity of the economy is reduced, as is the ability of
individuals to purchase goods at now-higher prices. GDP, therefore, tends to fall.
How can we relate this framework to investment analysis? You want to identify the indus-
tries that will be most helped or hurt in any macroeconomic scenario you envision. For exam-
ple, if you forecast a tightening of the money supply, you might want to avoid industries such
as automobile producers that might be hurt by the likely increase in interest rates. We caution
you again that these forecasts are no easy task. Macroeconomic predictions are notoriously
unreliable. And again, you must be aware that in all likelihood your forecast will be made us-
ing only publicly available information. Any investment advantage you have will be a result
only of better analysis”not better information.
The nearby box gives an example of how investment advice is tied to macroeconomic fore-
casts. The article focuses on the different advice being given by two prominent analysts with
differing views of the economy. The relatively bearish strategists believe the economy is about
to slow down. As a result, they recommend asset allocation toward the fixed-income market,
which will benefit if interest rates fall in a recession. Within the stock market, they recom-
mend industries with below-average sensitivity to macroeconomic conditions. Two recession-
resistant or “defensive” investments specifically cited are beverage and health care stocks,
both of which are expected to outperform the rest of the market as investors become aware of
the slowdown in growth. Conversely, the optimistic analysts recommend investments with
greater sensitivity to the business cycle.

As the previous section would suggest, the government has two broad classes of macroeco-
nomic tools”those that affect the demand for goods and services and those that affect their sup-
ply. For much of postwar history, demand-side policy has been of primary interest. The focus
has been on government spending, tax levels, and monetary policy. Since the 1980s, however,
increasing attention has also been focused on supply-side economics. Broadly interpreted, sup-
ply-side concerns have to do with enhancing the productive capacity of the economy, rather than
increasing the demand for the goods and services the economy can produce. In practice, supply-
side economists have focused on the appropriateness of the incentives to work, innovate, and
take risks that result from our system of taxation. However, issues such as national policies on
education, infrastructure (such as communication and transportation systems), and research and
development also are properly regarded as part of supply-side macroeconomic policy.

Fiscal Policy
Fiscal policy refers to the government™s spending and tax actions and is part of “demand-side
fiscal policy
management.” Fiscal policy is probably the most direct way either to stimulate or to slow the
The use of
economy. Decreases in government spending directly deflate the demand for goods and serv-
government spending
ices. Similarly, increases in tax rates immediately siphon income from consumers and result
and taxing for the
specific purpose of in fairly rapid decreases in consumption.
stabilizing the Ironically, although fiscal policy has the most immediate impact on the economy, the for-
mulation and implementation of such policy is usually painfully slow and involved. This is be-
cause fiscal policy requires enormous amounts of compromise between the executive and
legislative branches. Tax and spending policy must be initiated and voted on by Congress,
which requires considerable political negotiations, and any legislation passed must be signed
by the president, requiring more negotiation. Thus, while the impact of fiscal policy is relatively
Bodie’Kane’Marcus: IV. Security Analysis 11. Macroeconomic and © The McGraw’Hill
Essentials of Investments, Industry Analysis Companies, 2003


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