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Solutions 61

SOLUTIONS
1. The process of setting capital market expectations (CMEs) involves the following
seven steps:

A. Specify the set of expectations needed, including the time horizon(s) to

which they apply.
B. Research the historical record.
C. Specify the method(s) and/or model(s) to be used and their information
requirements.
D. Determine the best sources for information needs.
E. Interpret the current investment environment using the selected data and
methods, applying experience and judgment.
F. Provide the set of expectations needed, documenting conclusions.
G. Monitor actual outcomes and compare them with expectations, providing
feedback to improve the expectation-setting process.
The first step, which specifies the set of expectations needed, is carried out by
the firm. Wuyan, in developing a statistical model based on a dividend discount
method, researched the historical data seeking to identify the relevant variables
and determined the best source of data for the model. In her report, she also
noted her interpretation of the current economic and market environment. To
complete the process, Wuyan should complete Steps 6 and 7. Wuyan should pro-
vide the set of expectations needed, documenting the conclusions, and include
the reasoning and assumptions underlying the projections. Then, she should
monitor the actual outcomes and compare them with the expectations, provid-
ing feedback to assess and improve the accuracy of the process. The comparison
of the capital market expectations estimated by the model against actual results
provides a quantitative evaluation of forecast error. The feedback from this step
can be used to improve the expectation-setting process.

2. Discuss how each of the following forecasting challenges evident in Wuyan’s

report and in Tommanson’s comments affects the setting of capital market
expectations:

Status quo bias Tommanson’s statement that he is reluctant to underweight equities

given the strong performance of equities over the last quarter is an
example of status quo bias. His statement that the most recent quar-
terly data should be weighted more heavily in setting capital market
expectations is also an example of this bias. Status quo bias reflects
the tendency for forecasts to perpetuate recent observations and for
managers to then avoid making changes. Status quo bias can be miti-
gated by a disciplined effort to avoid anchoring on the status quo.
Data-mining bias In Wuyan’s report, data-mining bias arises from repeatedly search-
ing a data set until a statistically significant pattern emerges. Such a
pattern will almost inevitably occur, but the statistical relationship
cannot be expected to have predictive value. As a result, the modeling
results are unreliable. Irrelevant variables are often included in the
forecasting model. As a solution, the analyst should scrutinize the
variables selected and provide an economic rationale for each variable
selected in the forecasting model. A further test is to examine the
forecasting relationship out of sample.
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62 Learning Module 1 Capital Market Expectations, Part 1: Framework and Macro Considerations

Risk of regime The suggestion by Tommanson to extend the data series back
change increases the risk of the data representing more than one regime. A
change in regime is a shift in the technological, political, legal, eco-
nomic, or regulatory environments. Regime change alters the risk–
return relationship since the asset’s risk and return characteristics
vary with economic and market environments. Analysts can apply
statistical techniques that account for the regime change or simply
use only part of the whole data series.
Misinterpretation of Wuyan states that the high correlation between nominal GDP
correlation and equity returns implies nominal GDP predicts equity returns.
This statement is incorrect since high correlation does not imply
causation. In this case, nominal GDP could predict equity returns,
equity returns could predict nominal GDP, a third variable could pre-
dict both, or the relationship could merely be spurious. Correlation
does not allow the analyst to distinguish between these cases. As a
result, correlation relationships should not be used in a predictive
model without understanding the underlying linkages between the
variables.

3. The growth rate in the aggregate market value of equity is expressed as a sum
of the following four factors: (1) growth rate of nominal GDP, (2) the change in
the share of profits in GDP, (3) the change in P/E, and (4) the dividend yield. The
growth rate of nominal GDP is the sum of the growth of real GDP and inflation.
The growth rate of real GDP is estimated as the sum of the growth rate in the
labor input and the growth rate in labor productivity. Based on the chief econ-
omist’s estimates, the macroeconomic forecast indicates that nominal GDP will
increase by 4.0% (= 0.5% labor input + 1.3% productivity + 2.2% inflation).
Assuming a 2.8% dividend yield and no change in the share of profits in the
economy, Cambo’s forecast of a 9.0% annual increase in equity returns implies a
2.2% long-term contribution (i.e., 9.0% equity return − 4.0% nominal GDP − 2.8%
dividend yield) from an expansion in the P/E.

4.
Discuss, based on the chief economist’s prediction, the implications for the following:
In the late expansion phase of the business cycle, bond yields are
usually rising but more slowly than short-term interest rates are, so the
Bond yields
yield curve flattens. Private sector borrowing puts upward pressure on
rates while fiscal balances typically improve.
In the late expansion phase of the business cycle, stocks typically rise
but are subject to high volatility as investors become nervous about the
Equity returns restrictive monetary policy and signs of a looming economic slowdown.
Cyclical assets may underperform while inflation hedges, such as com-
modities, outperform.
In the late expansion phase of the business cycle, short-term interest
Short-term inter- rates are typically rising as monetary policy becomes restrictive because
est rates the economy is increasingly in danger of overheating. The central bank
may aim for a soft landing.

5.
Discuss strengths and weaknesses of the economic forecasting approaches used by Cambo
and the chief economist.
Chief Economist’s Forecasting
Cambo’s Forecasting Approach Approach
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Solutions 63

• The leading indicator–based • Econometric models can be

approach is simple since it requires quite robust and can examine
following a limited number of impact of many potential variables.
economic/financial variables. • New data may be collected and
• Can focus on individual or com- consistently used within mod-
posite variables that are read- els to quickly generate output.
Strengths
ily available and easy to track. • Models are useful for simulating effects
• Focuses on identifying/forecasting of changes in exogenous variables.
turning points in the business cycle. • Imposes discipline and consistency on
the forecaster and challenges modeler
to reassess prior view based on model
results.
• Data subject to frequent revi- • Models are complex and
sions resulting in “look-ahead” bias. time consuming to formulate.
• “Current” data not reliable • Requires future forecasts for the
as input for historical analysis. exogenous variables, which increases
• Overfitted in sample. Likely the estimation error for the model.
Weaknesses overstates forecast accuracy. • Model may be mis-specified,
• Can provide false signals and relationships among vari-
on the economic outlook. ables may change over time.
• May provide little more than • Models may give false sense of precision.
binary directional guidance (no/ • Models perform badly at forecasting
yes). turning points.

6. A is correct. Wakuluk started her career when the global markets were expe-
riencing significant volatility and poor returns. She is careful to base her con-
clusions on objective evidence and analytical procedures to mitigate potential
biases, which suggests she is seeking to mitigate an availability bias. Availability
bias is the tendency to be overly influenced by events that have left a strong im-
pression and/or for which it is easy to recall an example.

7. B is correct. Wakuluk’s approach to economic forecasting utilizes both a struc-

tural model (e.g., an econometric model approach) and a diffusion index (e.g.,
a leading indicator-based approach). However, the two approaches have weak-
nesses: An econometric model approach may give a false sense of precision, and
a leading indicator-based approach can provide false signals. Two strengths of
the checklist approach are its flexibility and limited complexity, although one
weakness is that it imposes no consistency of analysis across items or at different
points in time.

8. B is correct. Country Z is a developing market. Less-developed markets are likely

to be undergoing more rapid structural changes, which may require the analyst to
make more significant adjustments relative to past trends.

9. A is correct. Country X is predicted to be in the initial recovery phase of the busi-

ness cycle, which suggests short-term (money market) rates are low or bottom-
ing. Inflation is procyclical. It accelerates in the later stages of the business cycle
when the output gap has closed, and it decelerates when a large output gap puts
downward pressure on wages and prices, which often happens during a reces-
sion or the early years afterward. As long as short-term interest rates adjust with
expected inflation, cash is essentially a zero-duration, inflation-protected asset
that earns a floating real rate, which is typically procyclical. Wakuluk assumes
short-term interest rates adjust with expected inflation and are procyclical. Thus,
short-term rates are most likely to be low and bottoming if Country X is in the
initial recovery phase of the business cycle.
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64 Learning Module 1 Capital Market Expectations, Part 1: Framework and Macro Considerations

10. B is correct. Wakuluk’s model predicts that Country Z’s business cycle is current-
ly in the late upswing phase. In the late upswing phase, interest rates are typically
rising as monetary policy becomes more restrictive. Cyclical assets may under-
perform, whereas the yield curve is expected to continue to flatten.

11. C is correct. Monetary policy has been persistently loose for Country Y, while
fiscal policies have been persistently tight. With this combination of persistently
loose and tight policies, the impact could lead to higher or lower nominal rates
(typically labeled as mid-nominal rates).

12. C is correct. Country Y is expected to significantly increase transfer pay-

ments and introduce a more progressive tax regime. Both of these changes are
pro-growth government policies and should have a positive impact on the trend
rate of growth for a business cycle that is in slowdown or contraction. Transfer
payments help mitigate fluctuations in disposable income for the most vulnerable
households, while progressive tax regimes imply that the effective tax rate on the
private sector is pro-cyclical (i.e., rising as the economy expands and falling as the
economy contracts).

13. C is correct. The current yield curve for Country Y suggests that the business cy-
cle is in the slowdown phase (curve is flat to inverted), with bond yields starting
to reflect contractionary conditions (i.e., bond yields are declining). The curve
will most likely steepen near term, consistent with the transition to the contrac-
tionary phase of the business cycle, and be the steepest on the cusp of the initial
recovery phase.

14. Discuss the implications of Hadpret’s inflation forecast on the expected returns
of the fund’s holdings of:

Cash The fund benefits from its cyclically low holdings of cash. With the
economy contracting and inflation falling, short-term rates will likely be
in a sharp decline. Cash, or short-term interest-bearing instruments, is
unattractive in such an environment. However, deflation may make cash
particularly attractive if a “zero lower bound” is binding on the nominal
interest rate. Otherwise, deflation is simply a component of the required
short-term real rate.
Bonds The fund’s holdings of high-quality bonds will benefit from falling infla-
tion or deflation. Falling inflation results in capital gains as the expected
inflation component of bond yields falls. Persistent deflation benefits the
highest-quality bonds because it increases the purchasing power of their
cash flows. It will, however, impair the creditworthiness of lower-quality
debt.
Equities The fund’s holdings of asset-intensive and commodity-producing firms
will be negatively affected by falling inflation or deflation. Within the
equity market, higher inflation benefits firms with the ability to pass
along rising costs. In contrast, falling inflation or deflation is especially
detrimental for asset-intensive and commodity-producing firms unable to
pass along the price increases.
Real Estate The fund’s real estate holdings will be negatively affected by falling infla-
tion or deflation. Falling inflation or deflation will put downward pressure
on expected rental income and property values. Especially negatively
affected will be sub-prime properties that may have to cut rents sharply
to avoid rising vacancies.

15. Hadpret expects that, in response to a forecasted contraction in the Eastland

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Solutions 65

economy, the central bank will ease monetary policy and the government will
enact an expansionary fiscal policy. This policy mix has an impact on the shape of
the yield curve.
The impact of changes in monetary policy on the yield curve are fairly clear,
because changes in the yield curve’s slope—its flattening or steepening—are
largely determined by the expected movement in short rates. This movement, in
turn, is determined by the expected path of monetary policy and the state of the
economy. With the central bank easing and the economy contracting, policy rates
will be declining and will be expected to decline further as the central bank aims
to counteract downward momentum in the economy. Bond yields also decline
but by a lesser amount, so the yield curve steepens. The yield curve will typically
continue to steepen during the contraction phase as the central bank continues to
ease, reaching its steepest point just before the initial recovery phase.
Fiscal policy may affect the shape of the yield curve through the relative supply
of bonds at various maturities that the government issues to fund deficits. Unlike
the impact of monetary policy, the impact of changes in the supply of securities
on the yield curve is unclear. The evidence seems to suggest that sufficiently large
purchases/sales at different maturities will have only a temporary impact on
yields. As a result, the large government budget deficits forecasted by Hadpret
are unlikely to have much of a lasting impact on the yield curve, especially given
that private sector borrowing will be falling during the contraction, somewhat
offsetting the increase in the supply of government securities.

16. Discuss how interest rate and exchange rate linkages between Eastland and
Northland might change under each scenario. (Note: Consider each scenario
independently.)

Scenario 1 Eastland currently has a fixed exchange rate with unrestricted capital flows.
It is unable to pursue an independent monetary policy, and interest rates will
be equal to those in Northland. By restricting capital flows along with a fixed
exchange rate, Eastland will be able to run an independent monetary policy
with the central bank setting the policy rate. Thus, interest rates can be dif-
ferent in the two countries.
Scenario 2 Eastland currently has a fixed exchange rate pegged to Northland with unre-
stricted capital flows. Eastland is unable to pursue an independent monetary
policy with interest rates in Eastland equal to the interest rates prevailing
in Northland (the country to which the currency is pegged). If Eastland
allows the exchange rate to float, it will now be able to run an independent
monetary policy with interest rates determined in its domestic market. The
link between interest rates and exchange rates will now be largely expecta-
tional and will depend on the expected future path of the exchange rate. To
equalize risk-adjusted returns across countries, interest rates must generally
be higher (lower) in the country whose currency is expected to depreciate
(appreciate). This dynamic often leads to a situation where the currency
overshoots in one direction or the other.
Scenario 3 Eastland and Northland (with currencies pegged to each other) will share the
same yield curve if two conditions are met. First, unrestricted capital mobil-
ity must occur between them to ensure that risk-adjusted expected returns
will be equalized. Second, the exchange rate between the currencies must be
credibly fixed forever. Thus, as long as investors believe that there is no risk
in the future of a possible currency appreciation or depreciation, Eastland
and Northland will share the same yield curve. A shift in investors’ belief
in the credibility of the fixed exchange rate will likely cause risk and yield
differentials to emerge. This situation will cause the (default-free) yield curve
to differ between Eastland and Northland.