CHAPTER 17

MACROECONOMIC AND INDUSTRY ANALYSIS

Outline of the Chapter

 The macroeconomy
1. Key economic statistics
 Demand and supply shocks
 Fiscal and monetary policy
 The business cycles
 Economic indicators
 Industry analysis
1. Define an industry
2. Sensitivity of industries to the business cycle
3. Industry life cycles
4. Industry structure and performance

The Domestic Macroeconomy

 The macroeconomy is the environment in which all firms operate.
 Key economic statistics used to describe the state of the economy:
1. Gross domestic product
2. Employment
3. Inflation
4. Interest rates
5. Budget deficit
6. Sentiment
7. Foreign exchange (Global Economy)

•Gross Domestic Product (GDP)

 The measure of the economy’s 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.
•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.

•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.

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•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.
•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 foreign
countries and increases the exports and hence the GDP growth.

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.
•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 economy’s workforce or changes in the wage rate.
 Supply shocks cause the aggregate output move in the opposite direction of inflation and
interest rates.
Fiscal and Monetary Policy
•How can government affect the demand and supply of goods and services?
•Fiscal Policy
 The government’s 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.
•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 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

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•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

•Presents graphs of several measures of production and output.

•There is a generally rising trend with variations.
•The bottom graph of capacity utilization shows a cyclical pattern.
•Shaded areas show

•Cyclical vs Defensive Industries

 Cyclical industries are the ones that show above-average sensitivity to the business cycle,
state of the economy.
 High beta Stocks
 Defensive industries are the ones that show little sensitiviy to the business cycle.
• Low beta stocks
 Choose cyclical industries when you are optimistic about the economy and choose
defensive industries when you are pessimistic about the economy.

•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: averageweekly hours of production workers, stock prices
 Coincident indicators tend to change directly with the economy
•Examples: industrial production, manufacturing and trade sales

 Lagging indicators tend to follow the lag economic performance.

•Examples: ratio of trade inventories to sales

Industry Analysis
•Defining an industry
•Sensitivity to the Business Cycle
 Three factors decide the sensitivity of a firm’s earnings to the business cycle: sensitivity
of sales of the firm’s product to the business cycles, operating leverage, financial
leverage.
1. Sensitivity of sales
•Necessities such as foods, drugs, and medical services will show little sensitivity to business
conditions.

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•Firms in the industries such as steel, auto, and transportation are highly sensitive to the state of
the economy.

2. Operating Leverage
•Division between variable and fixed costs.
•Firms with more variable costs are less sensitive to business conditions. Firm can reduce 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
•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)
3. Financial Leverage
•The use of borrowing. (Total debt/total equity)
•The interest payments on debt is a fixed costs and Increase the sensitivity of the firms to the
changes in the business cycle.

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

 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 consumer durablesand luxury items

•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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•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
•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.

•Industry Structure and Performance

–Porter’s (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

•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.

•Bargaining power of buyers

–If a buyer purchases a large fraction of an industry’s output, it will have considerable bargaining
power and ask for price reductions and reduces the profitability of the supplier.

•Bargaining power of suppliers

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–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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