Macro-Finance for Managers

Highlighting a Few Key Ideas and Issues

MF Basics:M&M Isn’t Just an Abstract Idea

M&M: Equity ≈ Debt For Corporate Finance:

▪ Value of firm projects (revenue, costs) matters a lot more than small differences in costs of funds

▪ Maybe liquidity issues at very high debt/equity ratios

For Macroeconomic Risks▪ Aggregate risk of projects (viability of

revenue/income streams) more critical than whether equity financed or debt financed (compare 1920s v. 2000s)

▪ Maybe liquidity issues at very high debt/equity or asset/equity ratios, especially in financial firms

MF Basics:Risk Drives Asset Prices

1970s Thinking: Changes in expected earnings (numerator) is the driver

2000 Thinking: 2000s: Changes in risk (denominator) is the driver

2008 Crisis demonstrates the importance of the evaluation of risk to asset prices in the aggregate

Managerial Implications Rapid shifts over time possible with variable denominator P-E Ratios (or P/GDP) as Long Run Predictor

▪ Very High P/E = current risk assessment overly optimistic

▪ Very Low P/E = current risk assessment overly pessimistic

PE-Ratio and Long Term Risks:http://www.econ.yale.edu/~shiller/data.htm

1860 1880 1900 1920 1940 1960 1980 2000 20200

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Price-Earnings Ratio

Long-Term Interest Rates

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MF Basics:Phillips Curve – A Tradeoff of More Money/Inflation for More Growth/Less Unemployment?

PE Ratios and SP500-GDP Ratio

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SP500/GDP (left scale)

SP500/Earnings (right scale)

MF Basics:The Fed, Markets, and Policy Limits

Fed & Rates: Taylor RuleTarget Rate = 2 + 0.5*(Actual Inflation – Target

Inflation) + 0.5*(Actual GDP – Potential GDP)

▪ Phillips Curve concept built-in

Markets & Rates: Fisher EquationMarket Rates = Real Rates + Expected Inflation

▪ Real Rates influenced by economic growth (higher when growth higher)▪ Estimate of Real Rate: TIPS (See Bloomberg Rates)

▪ Expected inflation influenced by Fed actions and velocity of money

Policy Limits: No interest rate “knob” for Fed; influences with money

creation “Insurance” for system-wide panics

Nominal 10-Year Treasury Rate andInflation-Adjusted Rate (TIPS)

Fisher Equation (Market Events --inflation, real rates) Can Dominate Fed Targets

1970s: Impact of expected inflation

2008: Real rates collapse

MF Basics:Debt-Currency-Inflation All Linked

Even for Governments: Expected PV of Liabilities = Expected PV of

Assets Liabilities = Money + Bonds Assets = Discounted PV of Tax Revenue –

Spending When Markets Come to Evaluate M + B issuance

much greater that PV(T-G) Debt-Currency-Inflation Crisis

▪ Germany 1920s, Mexico 1990s, Greece now, Italy? Spain?, Japan?, US?

Views/markets tend to switch all at once – “peso problem” so current market evaluation

Risks Ahead

Europe Now, Japan Around the Corner:http://www.econbrowser.com/archives/2012/08/how_long_can_ja.htmlhttp://media.chicagobooth.edu/mediasite/Viewer/?peid=f15d95d054e8442ab0cc1c60321383101d

Debt/GDP ratio must be viewed in relation to GDP growth potential, assets & savings, and likelihood of expenditure adjustments

Implications: Likelihood of low U.S. Treasuries through Japan issues

… U.S. Down the Line

Implication: U.S. Treasuries

Gauging Recession Risk

Managerial Actions: Limit new projects; Put off new hires; De-leverage …

Single Best Market Indicator:Yield Curve Slope (10 Year – 3 Month Treasury Rates)

The Treasury Yield Curve: Steep: High growth or inflation expected Flat/Inverted: Low growth or inflation

expected

US Treasury Site

"Living Yield Curve"

Yield Curve Slope and RecessionsFew False Positives or False Negatives

Few False Positives or False Negatives

Recession in Grey

Key Indicators of Asset Price Risk/Financial Market Stress

Managerial Actions:Limit risk; increase liquidity; cash in fixed price assets; no new projects; secure longer term deals; …

Remember: Individual market indicators often not very good at assessing turning points; looking for tell-tale indications

Composite Indexes from STL Fed and KC Fed

Interest Rate “Spreads”(LIBOR – TBill; Comm. Paper – Tbill)

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Kuwati Invasion

Asian Debt

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LIBOR – Tbill (TED) Spread

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KC-FSILIBOR-Tbill

Fannie-Freddie

BearStearns

Lehman-AIG

Gauging the Top and Bottom:When Are Markets Way too Optimistic or Pessimistic(Shiller P-E Ratio)

Real Estate Asset Price Risk: Housing Price to Rental Ratio

Inflation Risk, Govt Liability Risk: Nominal Rate – Inflation Indexed Rate(Beware: Turning Points Not Easily Forecasted)

Nominal 10-

Inflation Indexed Rate

Nominal Rate

2008 Crash

Glance at Financial Crisis of 08:Debt, Debt, and More Debt

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U.S. Debt -- right scale

Debt/GDP - left scale

Mortgage Debt + A Whole Lot More

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Total Debt/GDP

Non-house-govt/gdp

House-debt/gdp

Govt Debt/gdp

Role of Commercial Lending:Vegas City Center ($10B) Bond/Loan Financed

Why So Much Debt?

Cheap Credit Public Sector Backing (Fannie, Freddie,

Homeownership) High Leverage (Assets/Equity) for Investment

Banks (Bear, Lehman, Merrill …) + AIG Banks Lending on 25 years of growth/repayment Foreign Investment in US

NOTARIETY BUT TOO SMALL ▪ Securitization (Collateralized Debt: CDOs)▪ Derivatives (Credit Default Swaps)▪ Market-to-Market Accounting

Who So Much Attention on Mortgages as Cause? Mortgage-related securities marked-to-

market daily Immediately begin to reflect

deteriorating conditions in 2007 Commercial loans on bank books valued

by banks at their PV of expected cash flow Widespread writing down of these loans

doesn’t begin until 2009, giving appearance that mortgage market problems causing these problems

Problems already developing coincidental with mortgage problems in 2007-08

Gold Price Index (Aug 2007 = 100)Inflation Risk or Other Risks?

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Value of $ and Other Currencies:Falling While Gold Price Rising?

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$ per AU$FX per US$