An increase in domestic price level causes appreciation of the real exchange rate.
When interest rates rise (because of a higher price level), non-domestic investors increase their demand of domestic currency in the FX market because they want to earn higher interest rate on their savings. This increased demand will cause the domestic currency to appreciate, which in turn causes the real exchange rate to increase.
From an asset allocation perspective, it is important to determine the current phase of the business cycle as well as how fast the economy is growing relative to its sustainable growth rate. The expected return of equities and fixed-income securities for example, depends on estimates of the growth rate of GDP and inflation.
For Equities, GDP growth is the primary determinant of aggregate corporate profits.
For Fixed Income securities, the expected rate of inflation determines the spread between real and nominal rates of return.
General rule of thumb: Banks should maintain reserves at about 10% of GDP.
The two-year U.S. Treasury yield, typically moves in step with interest rate expectations.
40% Recovery rate is a common baseline assumption in practice for Corporate Bonds.
The assumed discount rate used to estimate pension obligations are generally based on market interest rates of high quality corporate fixed-income investments with a maturity profile similar to the timing of company's future pension payments.
Approximate Credit Spread can be calculated by (1-Recovery Rate)*Default Probability.
Use 40% recovery rate if you know the credit spread. That will give you the P.D.
Unlike payments to equity investors, payments to debt investors are fixed (per the indenture). If a company experiences financial success, its debt becomes less risky but its success does not increase the debt payments to its creditors. In contrast, if a company experiences financial distress, then it may not be able to pay its debt obligations (got riskier), thus credit analysis has a special concern with the sensitivity of debt paying ability in times of adverse economic conditions.
If you take EPS of $220 next year and divide with the expected revenue per share of around $1,800 which fits pretty well with a 1-year lag in US nominal GDP growth, then you get a net profit margin of 12.2% which exactly where the 12-month trailing net profit margin stood at in September,” Ganry says
Many businesses will have no choice but to cut back on dividends and on share buy-backs, which will squeeze investor returns. High payout rates in America—equivalent to 63% of operating cashflow, compared with 41% in Europe—have helped push American share prices relative to earnings well above those in most other markets.
Low Capital Expenditures as compared to Depreciation expense could imply management is not adequately investing in its business, which in-turn may result in lower operating cash flow in the future.
Comparing annual CapEx to annual depreciation expense provides an indication of whether the productive capacity is being maintained by the company.
High FCF margins (i.e., free cash flow as a percentage of sales) can afford to make dividend payments and acquisitions, buy back stock, reduce debt, or just let the cash pile up on the balance sheet. Generally, any company with a 20% or greater FCF margin can be considered a cash cow.
In 2020 the median American investment-grade firm held cash worth 6.5% of its assets, more than at any time in the past 30 years. This figure has since been eroded to 4.5%, or around the same level as in 2010, after the global financial crisis. As a result, firms now have less scope to run down their existing cash reserves if interest rates stay high, and are more likely to need to borrow in response to future shocks.
Keep track of M2 and Inflation. M2 money supply represents less-liquid savings e.g CDs and when that number is falling, it can mean consumers are emptying their savings.
Deflation increase the value of real debt and inflation reduces the value of real debt
Borrowers are "happy" during inflation while Lenders are "happy" during deflation.
Quantitative easing simply means adding liquidity to the financial system. It is performed by "FOMC" via bond buying transaction and increasing reserves of the domestic banks.
Generally, the short-term volatility in bond prices is due to uncertainty regarding monetary policy and long-term volatility in bond prices is due to uncertainty regarding inflation and overall economy.
The ten-year is presently near 4.00% and using our simple bond math from discounting the yield curve, the two-year forward ten-year rate is 3.65%,” he said. And based on his prediction that ten-year rates will drop to 3.50% if the Fed cuts rates to 2%, he sees little profit in buying 10-year bonds. “I see a lot of risk to make a 15bp gain (about 1 point in price).” In short, Bassman said the yield curve is far too inverted even if inflation projections out there are optimistic relative to the Fed’s own politics and policies. So what should investors do about Wall Street’s wrong-way bet? The money manager sees an opportunity via the current shape of the yield curve. If the peak FED rate is 5.1% to 5.4% (FED Dots), then that is the limit for the UST 2yr (since the 2yr only exceeds the FED rate in anticipation of continued rate hikes). Conversely, a rate reduction can certainly be much greater (50bp up vs 300bp down) offering an unbalanced return profile. This is the definition of positive convexity,” he said. Traditionally, the main reason investors are willing to take a lower yield for a longer maturity bond (yield curve inversion) is to pick up the greater duration, and thus superior price performance if interest rates decline.
Off the run treasuries of the same duration are cheaper than the on the run treasuries. This is because of an additional liquidity premium assigned to On the run treasuries.
On an average since 1996 The ICE BofA U.S. High Yield index offers about 5 percentage points more yield than equivalent-maturity Treasurys. In all three recessions since then, this spread rose above 10 percentage points as investors worried about defaults.
If asset returns were perfectly negatively correlated, portfolio risk could be eliminated altogether for a specific set of asset weights.
When short-term yields are higher, it is a sign traders think rate cuts—typically prompted by a slowdown or a recession may be ahead.
Reinvested earnings enhance solvency and provide a cushion against short-term problems.
Generally, sectors and regions with stable earnings, low leverage, high return of equity and pricing power should fare better.
A major limitation of annualizing returns is the implicit assumption that money can be re-invested repeatedly while earning a similar return.
Nominal risk premium for US stocks is in the range of 4.5% to 6.5%. Global investors can expect an equity premium (relative to bills) of around 3½% on a geometric mean basis and, by implication, an arithmetic mean premium of approximately 5%.
The Taylor rule says that an increase in inflation by one percentage point should prompt the central bank to raise the nominal interest rate by more than one percentage point Since the real interest rate is (approximately) the nominal interest rate minus inflation, when inflation rises, the real interest rate should be increased. The idea that the nominal interest rate should be raised "more than one-for-one" to cool the economy when inflation increases (that is increasing the real interest rate) has been called the Taylor principle. If the Taylor principle is violated, then the inflation path may be unstable.
Loose credit conditions often lead to asset price and real estate bubbles that burst when capital market outflows and drawdowns occur mostly due to weaker fundamentals.
Credit Cycles tend to be longer, deeper and sharper than business cycles. The average length of credit cycle is mostly found to be longer than the business cycle.
Correlation is the key in diversification of risk. Lower correlation results in lower risk.
Two fund separation theorem states that all investors regardless of taste, risk preferences and initial wealth will hold a combination of two portfolios: a risk-free asset and an optimal portfolio of risky assets.
The CAPM asserts that the expected returns of assets vary only by their systematic risk as measured by beta. Two assets with the same beta will have the same expected return irrespective of the nature of those assets.
The current price of an asset is the discounted value of future cash flows . One of the models to determine discounted rate is CAPM. The discounted rate can then be applied to PV/FV or NPV formula to determine the PV/NPV of the asset.
Risk is defined as standard deviation of returns.
Bollinger bands are a technical tool that puts a band 2 standard deviations above and below a simple moving average. Signs of an overbought asset come with a move above that top band. The RSI indicator is often used to confirm what Bollinger bands are saying.
Investor should look at the basis for any investment recommendation to see whether it is anchored to previous estimates or some "default" number.
Like any homogenous good, utility prices are set by the most expensive supplier.
Investor should carefully record their investment decisions and key reasons for making those decisions at around the time the decision is made.
The equities of certain industry sectors tend to perform best at the beginning of an economic cycle. These sectors include financials, consumer non-durables and transportation. As an economic recovery gets underway, retailers, manufacturers, healthcare and consumer durables tend to outperform. Lagging sectors sometimes include those tied to commodity prices, which may catchup only in late-cycle, increasingly inflationary periods. In the final stage of a waning expansion, utility and consumer staple stocks may outperform while transportation stocks often lead early market weakness in anticipation of a softening economy.
Higher inflation and rising interest rates should translate into lower prices for equities and bonds. This is because future cash flows are discounted at a higher rate. Thus, higher inflation uncertainty should trigger larger, synchronized swings in the discount rates of equities and bonds, which would result in an upward shift in the bonds-equities correlation and reduce the diversification potential of bonds. This is indeed what we have witnessed over the past two years. In contrast, growth shocks should primarily affect equities, via a depressed earnings growth outlook and lower expected dividends. Bonds, on the contrary, may benefit from such a scenario as yields fall on the back of lower inflation expectations and ultimately looser monetary policy. With growth risks abounding at the moment, conventional wisdom suggests that we should see a retracement of the bonds-equities correlation. The problem is that inflation uncertainty remains a concern for the immediate future, particularly against the backdrop of geopolitical tensions and the looming energy crisis. Additionally, while inflation may eventually come off the current highs, the risks are skewed toward a protracted tightening cycle, which would lead to rising real yields. Rising real yields would prevent bond prices from rallying at a time when equities come under further pressure, limiting their diversification benefits and keeping the bonds-equities correlation at elevated levels. In our view, 2023 may present a bifurcated picture. Initially, the bonds-equities correlation should remain elevated, limiting bonds’ diversification potential. However, as inflation uncertainty peaks and the focus shifts to growth risks, the bonds-equities correlation should start to drift lower, making bonds more attractive from both a returns and diversification perspective. The caveat is that this shift in focus may take time, and that extended hawkish central bank action may keep the bonds-equities correlation above the levels seen in the past two decades.
Stocks and bonds react to growth shocks in opposite ways: stocks go up and bonds go down. But stocks and bonds react in the same direction to inflation shocks: stocks go down and bonds usually go down more
Since 1900, the US equity market has generated an annualized real return of 6.4% (and a normal return of 9.5%)
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