ECON 612 ECON 612 Macroeconomics for Macroeconomics for Financial ForecastingFinancial Forecasting

Class 4Class 4

Consumption, Saving, InvestmentConsumption, Saving, Investment

ConsumptionConsumptionThe relationship between economic slowdowns and bear markets is remarkably consistent, though not infallible, over many cycles.

Most bear markets begin when the year-over-year rate of growth in consumer spending is peaking, and investor and general business optimism are at their highest! Considerable courage is required to reduce investments at such times.

http://www.bea.gov/bea/dn/nipaweb/SelectTable.asp#S2 Table 2.3.3

ConsumptionConsumption

4

ConsumptionConsumption

This suggests that finding an effective discipline for forecasting consumer spending is essential for stock market exposure.

Leading indicator = a Leading indicator = a measurable economic factor measurable economic factor that changes that changes beforebefore the the economy starts to follow a economy starts to follow a particular pattern or trendparticular pattern or trend

From GDI To Personal From GDI To Personal IncomeIncome

Personal incomePersonal income is the total income of is the total income of households. Equals (national income) households. Equals (national income) minus (corporate profits minus minus (corporate profits minus dividends) minus (social insurance dividends) minus (social insurance payments) plus (interest income received payments) plus (interest income received from the government and households).from the government and households).

Disposable incomeDisposable income is the income is the income received by households after paying received by households after paying personal income taxes.personal income taxes.

Consumption TheoryConsumption Theory

The theory of consumption was developed by

Milton Friedman in the 1950s, who called it the

permanent income theory of consumption, and

by Franco Modigliani, who called it the life cycle

theory of consumption.

ConsumptionConsumption

Consumption is an increasing function of total Consumption is an increasing function of total

wealth, and also an increasing function after-tax wealth, and also an increasing function after-tax

labor income. labor income.

Total wealth is the sum of nonhuman wealth – Total wealth is the sum of nonhuman wealth –

financial wealth plus housing wealth – and financial wealth plus housing wealth – and human human

wealth – the present value of expected after-tax wealth – the present value of expected after-tax

income : income :

C C to ta l w ea l Y Tt L T t ( , )th t

The Role of ExpectationsThe Role of Expectations

Expectations affect consumption in two Expectations affect consumption in two ways:ways:

Directly through Directly through human wealthhuman wealth, or expectations , or expectations of future labor income, real interest rates, and of future labor income, real interest rates, and taxes.taxes.

Indirectly through Indirectly through nonhuman wealthnonhuman wealth - stocks, - stocks, bonds, and housing. Expectations of the value of bonds, and housing. Expectations of the value of nonhuman wealth is computed by financial nonhuman wealth is computed by financial markets.markets.

This dependence of consumption on This dependence of consumption on expectations has two main expectations has two main implications for the relation between implications for the relation between consumption and income:consumption and income:

Consumption is likely to respond less Consumption is likely to respond less than one for one to fluctuations in than one for one to fluctuations in current income.current income.

Consumption may move even if Consumption may move even if current income does not change (current income does not change (due due to changes in consumer confidence).to changes in consumer confidence).

ExpectationsExpectations

ConsumptionConsumptionAssumption: Consumption depends on current income.

The Consumer Confidence Index The Consumer Confidence Index (compiled by The Conference (compiled by The Conference Board) and Board) and the University of Michigan’s the University of Michigan’s Consumer Sentiment Index are Consumer Sentiment Index are based largely on based largely on questions asked of consumers questions asked of consumers regarding their expectations of regarding their expectations of future economic conditions. future economic conditions.

http://www.conference-http://www.conference-board.org/board.org/

Can we proxy C.ECan we proxy C.E

How it is measured?How it is measured?

Monthly from household survey.Monthly from household survey.

Survey of consumer opinion on Survey of consumer opinion on current condition and future current condition and future expectations.expectations.

3 separate headline figures: 3 separate headline figures: - How people feel currently (Index of Consumer Sentiment)- How people feel currently (Index of Consumer Sentiment)- How they feel the general economy is going (Current - How they feel the general economy is going (Current

Economic Conditions)Economic Conditions)-How they see things in six months’ time-How they see things in six months’ time

Q-1 How would you rate present general Q-1 How would you rate present general business conditions in your area? business conditions in your area? (good/normal/bad)(good/normal/bad)

Q-2 What would you say about available Q-2 What would you say about available jobs in your area right now? (plentiful/not jobs in your area right now? (plentiful/not so many/hard to get)so many/hard to get)

Q-3 Six months from now, do you think Q-3 Six months from now, do you think business condition in your area will be business condition in your area will be (better/same/ worse)?(better/same/ worse)?

Survey questions:Survey questions:

How it is measured?How it is measured?

Consumer confidenceConsumer confidence

Consumer confidenceConsumer confidence

Retail Sales

The retail sales report is a measure of the total receipts of retail stores.

Retail sales are often viewed ex-autos, as auto sales can move sharply from month-to-month.

It is also important to keep an eye on the gas and food components, where changes in sales are often a result of price changes rather than shifting consumer demand.

Retail Sales

Retail Sales

The Economic CycleThe Economic Cycle

US DebtUS Debt

21

Household DebtHousehold Debt

22

Household DebtHousehold Debt

24

“Healthy, sustainable increases in real GDP and rising standards of living are incompatible with an economy where input has replaced output and the product of a nation’s endeavors is a growing mountain of debt—with the byproduct being a dwindling number of wealth-generating assets serving as a source of repayment.”

Richard Eckert, CFALahde Capital, CFO / Risk Manager

December 17, 2007

Household Debt Household Debt Americans have chosen to bridge the gap between their real, after-tax income and their spending in recent years with increased borrowings.

In addition to borrowing outright, U.S. consumers seem to have dipped into their savings—both their cash and non-cash savings (i.e., through the monetization of their assets, including their home equity).

Declining home values and the apparent retreat of the capital markets from the housing finance sector have left many U.S. without access to what has been an important source of liquidity.

Therefore, equity extraction from houses will fall off, and people will return to spending what they actually earn. Such a transition spells slower consumption and real GDP growth over the foreseeable future.

SavingSaving

Personal savings is still at the lowest point since Personal savings is still at the lowest point since the Great Depression.the Great Depression.

U.S. Personal Saving1929 - 2006(Revised)

-200

-100

0

100

200

300

400

$ i

n b

illi

on

s

-5

0

5

10

15

20

25

30

%

Personal saving ($ in billions)

Personal saving (% of disposable personalincome)

Source: U.S. Dept. of Commerce, Bureau of Economic Analysis

Forecasting SavingsForecasting Savings

27

Forecasting Long Run Forecasting Long Run ConsumptionConsumption

28

InvestmentInvestmentAre included purchases of new produced Are included purchases of new produced machinery, tools, equipment construction, (both machinery, tools, equipment construction, (both residential and business) and changes in residential and business) and changes in

business business inventories.inventories.

If firms produce more than what they sell, the If firms produce more than what they sell, the unsold good go into their inventories. But such unsold good go into their inventories. But such undesired increase in inventories prompt the undesired increase in inventories prompt the

businesses businesses to reduce production in subsequent periods.to reduce production in subsequent periods.

Residential Investment

Future of InvestmentFuture of Investment

31

Future of InvestmentFuture of Investment

32

Corporate debtCorporate debt

33

PCE and InvestmentPCE and Investment

The Inventory CycleThe Inventory Cycle

35

InventoriesInventories