Business Cycles and

Corporate Management

Prof. Dr. Oscar Bernal – [email protected]

Lille, October 2017

 General information
• Business cycles and corporate management: one
course, three speakers
– Oscar Bernal (Professor of Finance at UNamur; and fellow at the
Solvay Brussels School of Economics and Management); 8h
– Philippe Ledent (Senior Economist at ING Bank); 4h
– Caroline Cleppert (Manager at KPMG); 4h
• Course grading
(i) Multiple choice exam (50%)
(ii) Written report on sectorial risk (groups of 4-5 students) (50%)
• This course differs in its presentation from BCCM
given in Paris but not in its content

2
 Country risk report instructions
• Objective
– Write a risk report for one specific sector of activity in one given country (groups of up to 5 students)
• Content of the report
– Country macroeconomic outlook (i.e. short term perspectives and upward and downward risks)
– Industry recent evolution (e.g. production, turnover and profitability, change in prices and labour
cost)
– Competition on the domestic market from a microeconomic point of view (e.g. number of firms,
rivalry, segmentation, etc.) and brief presentation of foreign competitors
– Domestic and international sales vs. domestic or international indicator
– Perspectives in the short term (using all relevant indicators with an emphasis on sales, volume, prices
and profitability
– Conclusion (i.e. what implications can be drawn for managers willing to launch a productive activity
in the sector and country of interest)
• More details will follow as soon as possible
• For any question
– With the processes, contact Matthieu Picault ([email protected]) with “BCCM – online process” as
title
– Related with the content of the project, ask your professors during the lectures or using their email
addresses

3
 Introduction
• Why BCA matters for corporates?
– Business cycles determine the economic environment in
which firms make business
– BC influence the behaviour of all the economic agents with
which firms interact
• BCA is essential to understand how the economic
system actually works
• BCA bridges economic theory to corporate
management by allowing the identification of
– Risks
– Opportunities

4
 Introduction
• Assessing the real economy’s outlook is difficult
– Lack of real time data
– Complex interactions
– Economic variables long-term relationships may not hold during
crises
• Financial markets too are difficult to understand
– Volatility has surged over the last 40 years
Tam quan trong
– Consequently, frequency and magnitude of financial crises has
increased
• Need to be able to elaborate a dynamic economic dashboard
• Helpful for designing “the big picture” of economic and
financial developments (think global)
• Foreseeing the economic outlook is key for the management
of any business (think about financing costs, labour costs, the
evolution of sales and profitability, etc.)
 Introduction
• Three main objectives of this lecture
– Discuss the main economic and financial
mechanisms
– Define the indicators allowing to monitor these
mechanisms
– Understand how these indicators interact and
help predicting economic and financial
developments to draw relevant conclusions in
terms of business management

6
 Contents
• Focus on several (key) economic/financial concepts
– Section 1: Economic growth (p. 8)
– Section 2: Expectations and data (p. 24)
– Section 2: Inflation (p. 29)
– Section 4: Bond markets and interest rates (p. 41)
– Section 5: Stock markets (p. 56)
– Section 6: Forex (p. 62)
– Section 7: Fiscal and monetary policy (p. 71)
– Section 8: Putting it all together (p. 96)
• Theoretical aspects will be addressed in this lecture
• Practical dimension (particularly how these tools can be used
by corporates in defining a financial scenario) will be
presented by Caroline Cleppert and Philippe Ledent

7
Section 1: Economic growth
 How to measure economic activity?

• GDP is the total production value of goods and services in an

economy
𝐺𝐷𝑃$ = ' 𝑃($ ×𝑄($
(

• GDP is a flow (measure of production value over a given year)

• Expenditures approach to GDP splits it in distinct components

GDP = C + I + G + X − M
• Role for the private sector (C and I), for the public sector (G)
and the rest of the world (X and M)

9
 GDP within the Eurozone
0 2000 4000 6000 8000

EZ 7850
GE 2400
FR 1700
IT 1250
SP 790
NL 500
BE 300
OE 250 GDP €bn
PIB en (2016)
milliards d'euros (2010)
GR 168
FI 166
IR 140
PT 135 Important heterogeneity
SK 53
LU 32
SL 25 France and Germany represent
CY 14 almost 50% of the EZ GDP
ES 9.6
MA 5

Source: Eurostat
10
 Real GDP
• What are the limitations of this definition of GDP?
– Nothing about wealth distribution within society
– Nothing about structure and diversification of the economy
– Nothing about GDP trend
– Inflation can create the illusion of GDP growth
• Better working with real GDP (or GDP in volume)
𝐺𝐷𝑃, = ' 𝑃, ×𝑄($ = 𝑃, ' 𝑄(,
( (

• T is the reference year (basis year)

• Increase of RGDP can only come from an increase of
QiT (hence the notion of GDP in volume)

11
 Real GDP growth
• In practise, (R)GDP statistics are useless
• Use (R)GDP growth instead
• Remark: from now on, GDP = RGDP
• RGDP growth only means that the economy was able to
produce more during a given period with respect to some
previous period, not that production capacity increased
• RGDP growth < 0 means recession while RGDP growth > 0
means economic expansion
• Several possible measures
– QoQ growth (% change wrt last quarter)
– YoY growth (% change wrt same quarter previous year)
– Annualized QoQ growth (% GDP growth for the entire year if growth
remains constant; mostly used in the UK and in the US)

12
 Economic growth
EZ GDP EZ GDP QoQ % EZ GDP EZ GDP YoY %
Q1 2006 1837.07 0.82 1837.07 2.65
Q2 2006 1856.82 1.08 1856.82 3.01
Q3 2006 1866.92 0.54 1866.92 2.92
Q4 2006 1882.34 0.83 1882.34 3.30
Q1 2007 1902.65 1.08 1902.65 3.57
Q2 2007 1911.28 0.45 1911.28 2.93
Q3 2007 1922.94 0.61 1922.94 3.00
Q4 2007 1929.34 0.33 1929.34 2.50
Q1 2008 1946.59 0.89 1946.59 2.31
Q2 2008 1943.1 -0.18 1943.1 1.66
Q3 2008 1939.47 -0.19 1939.47 0.86
Source: Eurostat
13
 QoQ and YoY growth measures are
complementary
2.5 6
2
4
1.5
1 2
0.5
0
0
-0.5 -2
-1
-4
-1.5
-2 -6
90 92 94 96 98 00 02 04 06 08 10

US GDP QoQ % US GDP YoY %

Source: Macrobond Financial

14
 Understanding growth
• Need to disentangle
go roi

– Structural determinants (long term)

• Demography = extensive growth
• Productivity = intensive growth
– Conjuncture determinants (short term)
• Inventories cycle
• Investment cycle
• Credit cycle
• The economic system can be affected by shocks that
can be of different types
– Supply vs. demand
– Domestic vs. external

15
 Main challenge
• Analysing economic growth poses one main
challenge: differentiate the short term dynamics
from the long term dynamics of growth
• In other words, is a GDP drop/increase the sign
– That GDP is below/above its trend?
– Or rather the sign that it is the trend itself that has
changed?
• To do so, analysts rely on several indicators and not
necessarily on growth statistics
• Why?

16
 Problem of lag
• GDP statistics are available only on a quarterly basis
• Furthermore, data releases come with a substantial
delay
• Final US Q2 GDP growth data have been published in
late September 2017
• BEA: http://www.bea.gov
• One quarter after the quarter in question ended
• Predicting the past is useless
• Other indicators are needed
• Need to talk about leading indicators

17
 Other indicators of economic activity
• To have a “on time” measure of economic activity, other
indicators must be used
• “Hard” indicators measure real economic activity
– Industrial production
– Retail sales
– Etc.
• “Soft” indicators measure ‘economic’ sentiment
– Ifo (Europe)
– PMI (World)
– ISM (US)
– Consumer confidence (World)
– Outlook leading indicators (World)
– Etc.
• Let’s see how this works

18
 Industrial production and retail sales yearly growth vs.
yearly GDP growth in the EZ

15 6 6 6
10 4
4 4
5
2
2 2
0
0
-5 0 0
-2
-10
-15
Last GDP (rhs) stat: t-3 -2
-4 Last GDP (rhs) stat: t-3 -2

-20 Lastchiffre
Dernier IP stat: t-1Q1
pour le PIB:
Dernier chiffre pour la prod. Indus.: Avril
-4
-6 Lastchiffre
Dernier RSpourstat: t-1
le PIB: Q1 -4
Dernier chiffre pour les ventes au détail.: Avril
-25 -6 -8 -6
Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10
Source: Eurostat
EZ Production industrielle (YoY %) EZ PIB (YoY %: rhs) EZ Ventes au détail (YoY %) EZ PIB (YoY %: rhs)

• Strong correlation between GDP and industrial production or retail sales

• IP and RS permit to assess the economic growth momentum at a given
time…
• … and provide supply-side and demand-side information for economic
activity
• IP and RS do have a direct economic interpretation

19
 Ifo and consumer confidence vs. yearly GDP growth in
the EZ
120 6 5 6
115 0
4 4
110 -5
105 -10 2
2
100
-15
95 0 0
-20
90
85 Last GDP (rhs) stat: t-3
Dernier chiffre pour le PIB: Q1 -2 -25 Last
DernierGDP (rhs)
chiffre pour le PIB:stat:
Q1 t-3 -2
Dernier chiffre pour la CC: Mai
80
Dernier chiffre pour l'Ifo: Mai
Last Ifo stat: t-0 -4
-30
Last CC stat: t-0 -4
75 -35
70 -6 -40 -6
Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10

Source: Eurostat
Climat des affaires en Allemagne (Ifo) EZ PIB (YoY %: rhs) Confiance des consommateurs EZ PIB (YoY %: rhs)
• Ifo measures the “business climate” in the Eurozone and has a “current” and
a “future” component
• The “consumer confidence” index measures the “economic sentiment” and
is made of several components (e.g. expected evolution of income,
unemployment, buying intentions, etc.)
• Ifo and CC permit to assess economic growth momentum (even though they
can be biased)
• Ifo and CC absolute values don’t have a direct economic interpretation
20
 ISM & PMI vs. yearly GDP growth in the US

65 6 65 6

60 4 60 4
55 55
2 2
50 50
0 0
45 45

40 Last GDP (rhs) stat: t-3 -2

40 Last GDP (rhs) stat: t-3 -2
Dernier chiffre pour le PIB: Q1 Dernier chiffre pour le PIB: Q1
35 Last chiffre
Dernier ISMpour stat:
l'ISM: t-0
Mai -4 35 Last
Dernier PMI stat:
chiffre pour t-0Mai
le PMI: -4

30 -6 30 -6
Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10

Source: Macrobond Financial

PMI Composite EZ PIB (YoY %: rhs)
ISM manufacturier US PIB (YoY %: rhs)

• ISM and PMI are diffusion indices

• Difference between positive and negative opinions of purchasing managers
regarding the evolution of business in their respective sector
• A value > 50 is consistent with economic expansion
• A value < 50 is consistent with economic contraction

21
 What about unemployment?
10,5 6

10 4
9,5
2
9
0
8,5
-2
8
GDP (rhs)
7,5 -4
EZ Unemployment rate
7 -6
Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10
Source: Eurostat
• The unemployment rate isdea chômage
EZ Taux key economic
(%) indicator
EZ PIB (YoYand gives direct
%: rhs)
information concerning the state of the labour market
• However, it gives poor information regarding the current state of the
economy
• The unemployment rate is rather seen as a lagging economic indicator

22
 Wrapping up
• Use soft indicators (leading indicators) to assess the
economic outlook
– Ifo or CC for July, August and September are already
available and provide a good feeling of how well the
economy performed during Q2 while the latest GDP data
only concerns Q1
• Confirm conclusions with hard indicators (lagging
indicators)
– Look at IP or RS that are available up to August to confirm
the conclusions provided by soft indicators
• Never focus on one single point, rather use the
evolution over several months or even quarters to
capture the general trend followed by economic
activity
• What does this mean for corporates?
23
Section 2: Expectations and data
 Indicators and data
• Elaborate an accurate view on economic
growth and inflation is the ultimate objective
of BCA
• Several indicators are used by economic
agents to make their opinion
• Economic and financial data providers give
useful information concerning this process
• Following screens were obtained in
Bloomberg

25
26
27
The role of surprises

28
 Asymmetries
• Since economic agents and markets are forward-
looking, economic/financial data surprises are
important
• Even more important in the presence of inefficient
markets
• Occur when actual data differs substantially from so-
called market consensus
• Surprises are big market movers even though their
effect is not necessarily symmetrical
• Economic agents react more to bad news than to
equivalent-in-magnitude good news
29
Section 3: Inflation
 Consumer price index
• Inflation is the yearly growth of a consumer price index (CPI)
• Important to distinguish headline inflation from core inflation
• Headline inflation is usually more volatile
• This volatility comes mostly from specific components of the CPI such as
energy prices

31
 Headline inflation vs. core inflation
6
5
4
3
2
1
0
-1
US core inflation
-2
US headline inflation
-3
J-96 O-98 F-01 J-03 O-05 F-08 J-10
Source: Macrobond Financial
US Inflation sous-jacente US inflation

32
 Inflation and oil prices
16 160
US inflation
14 140
Oil prices (USD, rhs)
12
120
10
100
8
6 80
4
60
2
40
0
20
-2
-4 0
60 65 70 75 80 85 90 95 00 05 10
Source: Macrobond Financial
US CPI (% YoY) Pétrole (USD; rhs)

33
 Computing inflation
EZ CPI EZ CPI MoM % EZ CPI EZ CPI YoY %
1/15/2007 102.51 -0.51 102.51 1.84
2/15/2007 102.81 0.29 102.81 1.84
3/15/2007 103.5 0.67 103.5 1.94
4/15/2007 104.15 0.63 104.15 1.91
5/15/2007 104.4 0.24 104.4 1.87
6/15/2007 104.5 0.10 104.5 1.89
7/15/2007 104.25 -0.24 104.25 1.78
8/15/2007 104.31 0.06 104.31 1.75
9/15/2007 104.71 0.38 104.71 2.14
10/15/2007 105.22 0.49 105.22 2.55
11/15/2007 105.78 0.53 105.78 3.06
12/15/2007 106.2 0.40 106.2 3.07
1/15/2008 105.8 -0.38 105.8 3.21
2/15/2008 106.17 0.35 106.17 3.27
3/15/2008 107.21 0.98 107.21 3.58
4/15/2008 107.55 0.32 107.55 3.26
5/15/2008 108.23 0.63 108.23 3.67
6/15/2008 108.64 0.38 108.64 3.96
7/15/2008 108.47 -0.16 108.47 4.05
8/15/2008 108.32 -0.14 108.32 3.84
9/15/2008 108.52 0.18 108.52 3.64
10/15/2008 108.55 0.03 108.55 3.16
11/15/2008 108.02 -0.49 108.02 2.12
12/15/2008 107.88 -0.13 107.88 1.58
Source: Eurostat 34
Inflation in the medium and long term
• Oil prices can be used to predict inflation over the
short term
• What about the medium and long term?
• “Inflation is always and everywhere a monetary
phenomenon” (M. Friedman)
• Money base is a leading indicator for inflation
• This however is not an universal result and rather
seems to hold in advanced economies only
(particularly in the US and in Europe)

35
 Money base vs. inflation

US inflation
12 16
US M3 % YoY (rhs)
10 14

8 12
10
6
8
4
6
2
4
0
2
-2 0
-4 -2
-6 -4
60 65 70 75 80 85 90 95 00 05 10
Source: Macrobond Financial
US CPI (% YoY) US M3 (% YoY; rhs)

36
Inflation and the economic outlook
• Inflation usually displays a tight link with the
state of the labour market
• Along these lines, inflation and economic
activity have a strong relationship
• This is summarised by the so-called Phillips
curve

37
 Inflation and employment
65 3.00

60
2.50
55

50 2.00

45
1.50
40

35
1.00
US core inflation
30 US ISM employment index (lead 20y; rhs)
25 0.50
01 02 03 04 05 06 07 08 09 10 11 12 13
Source: Macrobond Financial

38
 Inflation and unemployment
US inflation
12 12
US Unemployment rate (rhs)
10
10
8
6 8
4
6
2
0 4
-2
2
-4

-6 0
60 65 70 75 80 85 90 95 00 05 10
Source: Macrobond Financial
US CPI (% YoY) US Taux de chômage (% YoY; rhs)

39
Phillips curve

40
 Wrapping up
• Overall, inflation can be caused by
– Demand
– Costs
– Monetary conditions
• Analysing inflation developments is key to
understand competitiveness issues that is defined by
the ratio of domestic prices to foreign prices
• Inflation also matters for interest rates determination
(see section 4)
• What does this mean for corporates?

41
Section 4: Bond markets and
interest rates
 Bond supply and demand
• Interest rates are the result of supply and demand equilibrium
on the bond market
• Demand determinants
– Wealth & income (+) and propensity to save (+)
– Expected real (relative) return (+)
– Risk (-)
– Liquidity (+)
• Supply determinants
– Expected return on investment (+)
– Expected inflation (+)
– Fiscal policy (+)

43
 Inflation vs. interest rates
• When expected inflation
rises, bond prices
decrease… P (é) i (ê)

• … and interest rates increase

• This is called the Fisher
effect
• Allows to understand why
central banks most often
focus on prices stability
• Low inflation = low interest
rates which are good for the
economy

44
 Economic growth acceleration vs. interest rates

• The theoretical impact of

economic expansion on
P (é) i (ê)
interest rates is
undetermined
• In practise, bond supply
tends to increase more than
bond demand
• As a consequence, interest
rates increase when
economic activity is
accelerating
• This is not independent of
the central bank action

45
 Risk structure of interest rates
• Bonds with the same maturity can have different
interest rates
• Spreads can even vary accross time
• This is explained by
– Risk
– Liquidity & fiscal rules
US corp. BAA
US corp. AAA
15,5
US T-Bonds
13,5

11,5
Maturité: 10 ans
9,5

7,5

5,5

3,5 10y maturity

1,5
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Source: Macrobond Financial

US corp. AAA US corp. BAA US T-Bonds 46
 Corporate spreads in Europe
• Corporate spreads (= corp. – sov. bonds spread) = measure risk aversion
70 7

BBB credit spread in Europe 6

60

5
50

4
40
3

30 VDAX volatility index

2

20
1

10 0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Macrobond Financial

47
 Risk premium
• A supply & demand analysis permits to rationalize
the existence of a risk premium
– If default risk associated to a given bond increases, the
expected return of that bond decreases and demand for
that bond drops
– At the same time, the expected return of other bonds
(whose associated default risk has remained unchanged)
increases and demand for these bonds increase
• As a consequence, the interest rate of the more risky
bonds increases while the interest rate of the less
risky bonds decreases
• The difference is the risk premium

48
Explaining the risk premium with supply
and demand
P (é) i (ê) P (é) i (ê)

Risk
premium

Market for risky bonds Market for risk-free bonds

49
 Sovereign default risk
• Corporate spreads reflect the difference of risk between a
corporate bond and a sovereign
• Within a given country, the sovereign bond yield usually
corresponds to the risk-free rate
• The idea is that no corporate can be less risky than the country
in which it is established
• What about inter-sovereigns risk?
• Let’s consider the Eurozone case
– Eurozone countries are not considered as displaying the same level of
risk (e.g. German bund vs. Greek bonds)
– The difference of risk is reflected by
• Debt ratings
• Bond yields spreads

50
 Sovereign bond spreads in Europe
Bond spreads can increase to reflect the risk associated to a
given country. If spreads become to large, they can put the
debt sustainability of a given country in danger
20
18
16 Greece Germany
14 Ireland France
12
10
10y bonds Obligations d'Etat à 10 ans

8
6
4
2
J-01 D-02 J-04 D-05 J-07 D-08 J-10
Source: Eurostat
Allemagne France Irlande Grèce

51
 Term structure of interest rates
• Interest rates of bonds having the same level of risk and
submitted to the same fiscal rules can differ…
• … due to differences of maturity
• The yield curve summarizes this

6 French gov. bonds

5

2
3m 5y 10y Obligations d'Etat françaises
1

0
J-97 J-99 J-01 J-03 J-05 J-07 J-09 J-11

Source: Eurostat
3 mois 5 ans 10 ans

52
 Understanding the yield curve
• Bond yields are the sum of two components
– Average of expected short term interest rates
– Liquidity premium
e
it + it+1 +... + it+e (n−1)
int = + Lnt
n
• First component necessary for the non-arbitrage
condition to hold
• Second component is a compensation for investors
whose preferences are biased toward short term
maturities

53
 How to interpret the yield curve
slope?
i Strong interest rate i Moderate interest rate
growth expected growth expected (weak
(economic economic growth)
expansion)

Maturity Maturity

54
 How to interpret the yield curve
slope?
i Moderate decrease or i
stability of interest rates Strong decrease of interest
is expected (economic rates is expected (economic
stagnation) contraction)

Maturity Maturity

55
 Another way to look at the yield curve slope
US 10 Y – US 2Y (bp)
350

300

250

200
150

100
50
0

-50
-100
99 00 01 02 03 04 05 06 07 08 09 10 11 12

Source: Macrobond Financial

• What does this mean for corporates?

56
Section 5: Stock markets
Asset valuation and economic outlook
• Economic outlook influences corporates profits…
• … and their ability to pay dividends
• Assets prices equals the present value of future financial flows
• ke is the discount rate
D1 Dn Pn
P0 = +... + n
+ n
1+ ke ( e) ( e)
1+ k 1+ k

58
 Gordon-Shapiro
• Gordon-Shapiro is a model allowing to assess the
impact of the economic outlook on assets prices
Pn
– n
is omitted
(1+ ke )
– Dividends grow at a constant rate g
D1
– Current asset price becomes P0 =
ke − g
• Since ke and g are influenced by market rates and
economic growth…
• … the Gordon-Shapiro model provides powerful
insights on the impact of economic outlook on stock
markets
59
 Monetary policy and stock markets
• What is the impact of an interest rate cut on stock
markets?
– Policy rate cut leads to a decrease of short term rates and
of bond yields
– The discount rate ke in the economy decreases
– Stock market prices increase
• The story doesn’t end there…
– Weaker interest rates lead to more investment,
consumption and then to a stronger economic growth
– Dividend growth rises, which also sustain stock markets

60
 Market efficiency
• Market efficiency
– Can we forecast the evolution of financial
markets?
– Do they evolve with fundamentals ?
• At High frequency, close to random walk
• Does that mean that fundamentals are
irrelevant?
• Fundamentals are just information that
eventually is incorporated in prices as long as
markets are efficient
61
 Absence of arbitrage
• In efficient markets, there are no arbitrage opportunities =
there is no opportunity to get profits with certainty
• Earning money = taking risk, no free-lunch.
• This derives from the uniqueness of prices in the framework
of pure and perfect competition
• In practise, arbitrage opportunities may exist (very)
temporarily but financial agents called arbitragist drive prices
to the equilibrium
• Important to elaborate scenarios for g and k to foresee what
potential developments of P0 can be
• What does this mean for corporates?

62
Section 6: Forex
 Forex
• Currencies relative prices (= exchange rate) are set on the
foreign exchange market
• Foreign exchange market is decentralized
• Commercial and investment banks are the main players

Source: Euromoney 64
 The largest market in the world
• Two markets usually
monitored
– Spot market = immediate delivery
(our focus)
– Forward market = future delivery
(useful for hedging operations)
• Daily turnover > $bn 1000
• Short term dynamics of
exchange rates is difficult to
predict
à Interest rate parity condition (only
interest rates matter)
• Long term dynamics is easier
to assess
à Purchasing Power Parity theory
(PPP)
65
 Long term dynamics (5y or more)
• Purchasing power parity theory (PPP) states that
prices of two identical goods must not differ once
expressed in the same currency
• According to PPP, if prices increase by x% in a given
country, the country’s currency must depreciate by
x%
• In the long term, the PPP is generally verified…
• … even though important divergences can appear in
the short or medium term

66
 PPP

1.7 1.7

1.5 1.5

1.3 1.3

1.1 1.1

0.9 0.9

0.7 0.7

0.5 0.5
Jan-75 Jan-86 Jan-97 Jan-08

EUR/USD EUR/USD PPP

Source: Macrobond Financial

67
 Beyond prices

• Other factors influencing exchange rates in the

long term
– Trade barriers
– Productivity
– Consumer preferences (foreign vs. domestic
goods)
– Etc.
• It is possible to show that all these factors
eventually reduce to a question of price!

68
 Short term dynamics (up to 5y)
• Long term determinants of exchange rates
evolve rather slowly…
• … while exchange rates can fluctuate rapidly in
the short term
• In the short term, only interest rates matter
• Interest rates explain why investors hold one
type of asset rather than another
• This is reflected by the interest rate parity
condition
D
i −i F
=
( E e
t+1 − Et )
Et
69
 2-year spread and EUR/USD
2.50 1.60
Forecasting exchange
2.00 1.55
rates is difficult but it is
1.50 not necessarily the case of 1.50
interest rates
1.00 1.45

0.50 1.40

0 1.35

-0.50 1.30

-1.00 1.25

-1.50 2yr yield spread EUR - USD 1.20

EUR/USD
-2.00 1.15
2005 2006 2007 2008 2009 2010 2011

Source: Macrobond Financial

70
 Is it possible to reconcile the LT and ST dynamic
of exchange rates?
• Yes, through expectations
• When agents expect exchange rates to
depreciate/appreciate in the long term,
exchanges rates will adapt immediately
• The difficulty to build expectations on long
term factors explain (partially) the important
volatility of exchange rates observed in the
short term
• What does this mean for corporates?

71
Section 7: Fiscal and monetary policy
 Representing the economy

• To understand government interventions and

monetary policy, we need to formalize the
economy
• We rely on the IS/LM framework (short term,
closed economy macroeconomic model)
• IS (Investment and Savings) = equilibrium in the
market of goods and services
• LM (Liquidity preference and Money supply) =
equilibrium in the money market

73
 Equilibrium in the market of goods and services

• IS is the solution of a system of 3 equations

– Y = C + I + G (equilibrium)
– C = C0 + c (Y − T ) (consumption equation)
– I = I 0 − a (i − π e ) (investment equation)
• System solution given by
Y = C0 + cY − cT + I 0 − ai + aπ e + G
• Or, solving for i
C0 + I 0 + G − cT + aπ e (1− c) Y
iIS = −
a a

74
 IS
OA
DA, Y
DA1

DA2

45°

i2
i1

IS

Y
75
 Equilibrium in the money market
• LM is the solution of a system of 2 equations
s d
– M = M (equilibrium)
– M d = f (i,Y ) (money demand)
– M s = M means that money supply is exogenous
• Analytical solution requires assumptions regarding
money demand
• Linear demand often assumed: f (i,Y ) = M 0d + eY − hi
• Solving for i yields
M 0d − M eY
iLM = +
h h

76
 LM
!
%,!$&*$-" %,!#&*#-"
!"
!" %'"
"
"
"
" ."
!#"
"
" #"
!$"
$"

'+()" %&"'()" """"""""""""""""*$""""""""""*#"""""""""""""""""""*"

77
 Economic policy interactions

!
&'(!
&'! &'!
&'(! &'!

)*! )*! )*!

)*(! )*(! )*(!

!!!!!!!!!!"#!!!!!"$!!! !!!!!!!!!!"#!!!!"$!!"%!! !!!!!!!!!!!!!!!!!!!!!!"!!!

78
 Counter-cyclical stabilisation (fiscal policy)

• Fiscal policy consists in controlling public expenditures and revenues

• A discretionary rise of public expenditures coupled to a decrease of
taxes is the usual authorities’ response in case of economic downturn
• Automatic stabilizers also play a role
– Social security spending increase when the economic activity decelerates
– Collected taxes also decrease due to the fall of income

79
 Multiplier effect
• Y = GDP (expenditure approach)
• Assuming that
Y = C + I +G
C = C0 + cY
I = I0
• It arises that Y = C0 + cY + I 0 + G
• It is then obvious to see that Y = m × (C0 + I 0 + G )
1
m= ≥1
1− c
• Useful to assess the impact of an increase of public
expenditures on the economic output
80
 Fiscal policy limits
• To be efficient, fiscal policy must be sustainable
in the long term
• This supposes that recovery plans are financed
by resources…
• …accumulated in periods of strong economic
growth
• This is almost never the case

81
 No fiscal deficits cycle!
No!fiscal!deficits!cycle

Source: The Economist and The European Commission

www.unamur.be 53
82
Long term sustainability of public debt
• Public debt is just the accumulation of past
deficits
• Structural fiscal deficits can put the long term
sustainability of public debt in danger
• Furthermore, fiscal policy decisions usually
take a long time to be made
• Raises the risk that fiscal policy is pro-cyclical
(inefficient) rather than counter-cyclical

83
 The risk of public debt
Government debt (% GDP)

Source: Eurostat
84
 Monetary policy
• Monetary policy focuses on policy rates…
• … which are fixed in an attempt to control the
evolution of market rates
• The objective of most central banks is to ensure the
stability of prices and to favour growth and
employment
• Monetary policy decisions are usually taken faster
than fiscal policy measures
• However, the impact of monetary policy materializes
with a delay that can be of up to 24m

85
 Economic downturn sequence of events
1. Economic downturn
– Unemployment rises and consumption decreases, so as imports
– Corporates are confronted to bad profit perspectives and reduce investments to
avoid production overcapacity
– Inventories decrease
– If it is a global shock, exports also decrease
2. Authorities’ reaction
– Recovery plan consisting in rising public expenditures to enhance the role of
automatic stabilizers
– Central bank cuts policy rate to pressure short and long term interest rates
3. Consequences
– Public expenditures and weaker interest rates sustain national income and
consumption and investment
– Inflation and expected inflation rise
– Lower interest rates lead to a domestic currency depreciation
– Exports rise
– Economic growth rebounds
86
 What about the ECB?
• The ECB’s principal objective is to ensure prices stability within the
Eurozone
• Its mandate is much more restrictive than the Fed’s
• Inflation within the Eurozone has to remain between 0% and 2%...
• … in the medium term (allows for some tolerance vis-à-vis temporary
inflationary shocks)
• Explicitly, the ECB is supposed to fight against deflation (big current threat)

87
Two pillars strategy

88
 Policy rates
• Three policy rates
– Main refinancing rate (reference rate for
refinancing operations)
– Marginal lending facility rate
– Deposit facility rate

89
 Three policy rates
7

0
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Refi Lending facility rate

Deposit facility rate

Source: ECB
90
 Money market operations
• The ECB determines its policy rates to influence market rates
• The ECB also proceeds to regular refinancing operations aiming
at providing European banks with necessary liquidity
• Most important refinancing operations
– Main refinancing operations are conducted on a weekly basis with a
maturity of one week
– Long term refinancing operations are conducted every month with a
maturity of three months
– Fine tuning operations
– Structural operations

91
 ECB’s Monetary policy implementation

Source: ECB
92
 Auction mechanism for MROs
• Main refinancing operations take the form of an auction and are
repurchase agreements
• Every week, the ECB distributes a certain amount of liquidity to
European banks (the amount is not public information)
• Banks offer an interest rate that they are willing to pay to access to ECB’s
funding
• Once the auction is over, the ECB distributes the funds starting with the
bank having proposed the higher interest rate
• The ECB receives assets as collateral (usually government bonds)
• In normal circumstances, all banks participating to the auction are not
ensured to get funding
• During the financial crisis, the ECB replaced the auction mechanism with
a fixed rate tender mechanism with full allotment, it also decreased the
minimum rating requirement for collaterals

93
 Money market
• ECB’s refinancing operations are complementary to
refinancing operations that occur autonomously on
the money market
• Lending and deposit facility are meant to be only
marginal
• Main money market rates (not fixed by the ECB)
– EONIA (overnight)
– Euribor 3m

94
Policy rates vs. money market rates
7

0
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Refi Eonia Euribor 3m

Source: ECB

• What does this mean for corporates?

95
 To sum up

Source: ECB
96
Section 8: Putting it all together
 Real vs. financial economy
• Tight links between both parts of the economy
– Stock prices depend upon future profits that are
themselves influenced by economic activity
– Stock market developments impact corporates
investment decisions and households consumption
decisions
– A real shock can be amplified by financial markets
– Financial shocks can transmit to the real economy

98
 Real vs. financial economy
• Authorities also play a central role
– Central banks policy rates are key for
elaborating portfolios and hedging strategies
– Some financial variables can help predicting
economic activity developments

99
 Real vs. financial economy
5.00 5

4.50 4.5
4
4.00
3.5
3.50 3
3.00 2.5

2.50 2
1.5
2.00
1
1.50 0.5
1.00 0
Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07

Refi (lhs) EZ GDP YoY % (rhs)

Source: Eurostat
100
 Fiscal deficit and long term yields
• Deficit
à Creation of debt
à Bond prices decrease and bond yields increase
à Sovereign risk potentially rises
à Risk premium rises
• In periods of stress, this mechanism might not work if bond
demand is strong (safe heaven)
• In that case, the creation of debt will not necessarily translate
into higher sovereign bond yields
• This would only hold as long as there are no concerns regarding
the debt sustainability

101
 Stock markets and bond yields
• Consider that stock markets prices rise
à Bonds become relatively less interesting
à Bond prices drop and interest rates increase
• Consider that stock market prices decrease
à Bonds become relatively more interesting
à Bond prices increase and interest rates decrease
à “Flight to quality”

102
 Flight to quality
1300 5.5

1200 5

1100
4.5
1000
4
900
3.5
800
3
700

600 2.5

500 2
Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08

MSCI US bond 10y yield EZ bond 10y yield

Source: Macrobond Financial

103
 Inflation and bond yields
• Inflation expectations rise
à Bond issuances increase because the real cost of borrowing decreases
à Nominal long term yields increases
• But long term interest rates also are influenced by short term rates
à Long term interest rates = chain of short term rates
à Rising short term rates lead to higher long term rates
• Other factors can reinforce or weaken this mechanism
– Inflation
– Growth
– Risk premium
– Uncertainty
– Etc.

104
 A dashboard
GDP Inflation Forex Euribor 3m 10y yield Stock
Q4 2015 0.3 0.2 1.09 -0.12 0.99 4637
Q1 2016 0.6 -0.1 1.14 -0.22 0.41 4385
Q2 2016 -0.1 0.2 1.11 -0.27 0.20 4237
Q3 2016 0.7 0.3 1.12 -0.30 0.12 4448
Q4 2016 0.5 0.6 1.05 -0.32 0.68 4862
Q1 2017 0.5 1.1 1.07 -0.33 0.97 5122
Q2 2017 0.5 0.7 1.14 -0.33 0.82 5120
↑ ↑ ↑ = = =

↑ 2 consecutive quarters of growth

↓ 2 consecutive quarters of decline
= 1 quarter of growth and 1 quarter of decline or no evolution

105
 Conclusion
• Macroeconomics is important to financial markets
• Several financial variables depend upon macroeconomic developments
• Understanding economic mechanisms is key to understand the environment
in which our business evolves
• Don’t forget though that it is a two-way relationship
• Financial markets are forward looking and rely heavily upon expectations
• Expectations are key to underestand market movements
• Building up your own opinion and expectations on a given topic is
fundamental
• But don’t forget that the market consensus is also very important (even
though it is not always based on rational elements)

106