CHAPTER 17 MACROECONOMIC AND INDUSTRY ANALYSIS

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Outline of the Chapter

The macroeconomy
Key economic statistics

Demand and supply shocks Fiscal and monetary policy The business cycles Economic indicators Industry analysis
Define an industry Sensitivity of industries to the business cycle Industry life cycles Industry structure and performance

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The Domestic Macroeconomy

The macroeconomy is the environment in which all firms operate. Key economic statistics used to describe the state of the economy:
Gross domestic product Employment Inflation Interest rates Budget deficit Sentiment Foreign exchange (Global Economy)
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The Domestic Macroeconomy (Continued)

Gross Domestic Product (GDP)
The measure of the economys total production of goods and services. Rapid growth in GDP indicates an expanding economy and higher sales for the firms. Industrial production (IP): another measure of total output. It focuses on the manufacturing side of the economy.

Employment
Unemployment rate=number of those who are not working/total labor force (people who are either working or actively seeking employment) Measures the extent to which the economy is operating at full capacity.

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The Domestic Macroeconomy (Continued)

Inflation
The rate at which the general level of prices rise. High rates of inflation are associated with overheated economies. There is a trade-off between inflation and unemployment.

Interest Rates
Determinant for business investment expenditures. As interest rates increases the investment decreases so does the economic growth.

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The Domestic Macroeconomy (Continued)

Budget Deficit
The difference between government spending and revenues. The deficit should be closed by borrowing. The government borrowing can increase interest rates and crowd-out the private borrowing and decrease investment and affect economic growth negatively.

Sentiment
Beliefs (optimism and pessimism) of consumers and producers influence the levels of consumption and production and affect the aggregate demand for goods and services.
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The Global Economy

Exchange rate
The rate at which domestic currency can be converted into foreign currency. Affects the international competitiveness of the country. The depreciation of domestic currency makes the domestic products cheaper in foreing countries and increases the exports and hence the GDP growth.

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Demand and Supply Shocks

Demand shock
An event that affects the demand for goods and services in the economy. Examples for positive demand shocks: reduction in tax rates, increase in money supply, increases in government spending, increases in foreign exports. Usually characterized by aggregate output moving in the same direction as interest rates and inflation.

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Demand and Supply Shocks (Continued)

Supply shock
An event that influences production capacity and costs. Examples of supply shocks: changes in prices of intermediate goods such as oil, changes in the education level of an economys workforce or changes in the wage rate. Supply shocks cause the aggregate output move in the opposite direction of inflation and interest rates.

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Fiscal and Monetary Policy

How can government affect the demand and supply of goods and services? Fiscal Policy
The governments spending and tax actions. Decrease in government spending decrease the demand for goods and services while increase in tax rates decrease the income of consumers (households). If budget deficit>0 then government spend more than it earns and stimulate the economy.

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Fiscal and Monetary Policy (Continued)

Monetary Policy
The change in money supply to affect the macroeconomy. Increase in money supply will decrease short-term interest rates and cause an increase in investment and consumption demand. Implementation:
Changing monetary base (consists of currency and banks deposits in the central bank) by open market operations Changing the discount rate, is the interest rate the CB charges banks on short-term loans. Interbank rate Changing the required reserves ratio, the fraction of 17-11 deposits banks have to keep in the CB.

Business Cycles
Business Cycle:
The recurring pattern of recession and recovery. The economy recurrently experiences periods of expansion and contraction but the length and depth of those cycles can be different. The transition points across cycles are called peaks and troughs A peak is the transition from the end of an expansion to the start of a contraction A trough occurs at the bottom of a recession just as the economy enters a recovery

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Business Cycles (Continued)

Presents graphs of several measures of production and output. Threre is a generally rising trend with variations. The bottom graph of capacity utilization shows a cyclical pattern. Shaded areas show recessions.

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Business Cycles (Continued)

Cyclical vs Defensive Industries
Cyclical industries are the ones that show aboveaverage sensitivity to the business cycle, state of the economy. _______ beta stocks Defensive industries are the ones that show little sensitiviy to the business cycle. _______beta stocks Choose _______ industries when you are optimistic about the economy and choose _______industries when you are pessimistic about the economy.
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Business Cycles (Continued)

Economic Indicators
Set of cyclical indicators helps to forecast, measure, and interpret short-term fluctuations in economic activity. These indicators can be divided into three general groups as leading, coincident and lagging. Leading indicators tend to rise and fall in advance of the economy. Examples: average weekly hours of production workers, stock prices Coincident indicators tend to change directly with the economy Examples: industrial production, manufacturing and trade sales 17-15

Business Cycles (Continued)

Lagging indicators tend to follow the lag economic performance. Examples: ratio of trade inventories to sales

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Industry Analysis
Defining an industry
Employing North American Industry Classification Codes (NAICS). First 2 digit denotes very broad industry classification and the next digits define the industry grouping narrowly.

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Industry Analysis (Continued)

Sensitivity to the Business Cycle
Three factors decide the sensitivity of a firms earnings to the business cycle: sensitivity of sales of the firms product to the business cycles, operating leverage, financial leverage. Sensitivity of sales Necessities such as foods, drugs, and medical services will show little sensitivity to business conditions. Firms in the industries such as steel, auto, and transportation are highly sensitive to the state of the economy.
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Industry Analysis (Continued)

Operating Leverage Division between variable and fixed costs. Firms with more variable costs are _____ sensitive to business conditions. They can _______ costs as output falls in response to falling sales during economic downturn. Firms with high fixed costs are said to have high operating leverage because small changes in business conditions may have large impacts on profitability.

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Industry Analysis (Continued)

In order to quantify the operating leverage: Degree of operating leverage (DOL)=percentage change in profits/percentage change in sales. DOL=1+(Fixed costs/profits) Financial Leverage The use of borrowing. (Total debt/total equity) The interest payments on debt is a fixed costs and _________ the sensitivity of the firms to the changes in the business cycle.

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Industry Analysis (Continued)

Sector Rotation
Portfolio is adjusted by selecting companies that should perform well for the stage of the business cycle.

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Industry Analysis (Continued)

Peaks the economy might be overheated with high inflation and interest rates Time to invest in natural resource extraction firms, minerals and petroleum Contraction (recession)-the economy is getting smaller Time to invest in defensive industries such as pharmaceuticals and food Trough the economy is ready to recover, and then expand. Time to invest in capital goods industries, such as equipment, transportation or construction. Expansion the economy is growing Time to invest in cyclical industries such as 17-22 consumer durables and luxury items

Industry Analysis (Continued)

Industry Life Cycles
The industry life cycle might be described as four stages: Start-up stage: characterized by extremely rapid growth of sales and earnings Early stages of an industry New technology Difficult to predict which firms are going to be leaders. Some will be very successful some will fail

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Industry Analysis (Continued)

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Industry Analysis (Continued)

Consolidation stage: characterized by growth that is less rapid but still faster than the general economy Industry leaders begin to emerge Survivors from the start-up stage are more stable and the performance of the survivors closely track the performance of the industry Maturity stage: characterized by the growth no faster than the general economy The product has reached its full potential for use by the consumers. Producers compete on the basis of price Narrow profit margins
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Industry Analysis (Continued)

Relative decline stage: characterized by the growth less rapidly than the rest of the economy The product become obsolent Competition from new low-cost suppliers (or new products) Generally industries at the high-growth stages are more attractive for investment unless the stock prices already reflects likelihood for high growth.

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Industry Analysis (Continued)

Industry Structure and Performance
Porters (1985) determinants of competition Threat of entry High prices and profit margins will encourage entry by new competitors. Barriers to entry is a key determinant of industry profitability Secure distribution channels Brand loyalty Patent protection Experience in the market
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Industry Analysis (Continued)

Rivalry between existing competitors More price competition and lower profit margin Factors that affect the rivalry Slow industry growth High fixed costs Homogeneous products Pressure from substitute products Availiability of substitutes limits the prices that can be charged.

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Industry Analysis (Continued)

Bargaining power of buyers If a buyer purchases a large fraction of an industrys output, it will have considerable bargaining power and ask for price reductions and reduces the profitability of the supplier. Bargaining power of suppliers If a supplier of a key input has monopolistic control over the product, it can demand higher prices for the good and decrease the profits of the industry.

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