CFA Level II Economics: Economic Growth & Investment Decisions

[00:00:04]this is level two of the cfa program the topic on economics and the reading on economic growth and investment decisions remember back in uh financial reporting and analysis where i told you that the institute does not require us to be accountants but they ask us to think like accountants so that we can become better financial analysts well the same principle holds true in this reading the institute is not asking us to become economists but they're asking us to think like an economist so that we can become better financial analysts and it's a good thing too because the author of this reading is a gentleman who has a phd in economics but also holds the cfa designation and so that this reading is a great marriage between what we need from the economics literature regarding economic growth and then how we can apply it that's the second part the investment decision so let me give you just a brief introduction here so what do we know we know the economy can be measured let's suppose it's this size we know the economy can grow we know the economy can contract so when economies are growing what does that mean that means that there are increases in available positive net present value projects for companies not just domestically but globally as well and so as good financial analysts we need to identify those companies inside of the positive net present value framework so that we're better prepared to make these investment decisions and those investments decisions could be of course you know wealth management or asset allocation or something even more complex uh you know regarding the use of derivatives or maybe alternative investment strategies but the point here in this reading is that all right before we can make those investment decisions we need to know something about the macro economy we need to be able to predict economic growth it's one thing to say the economy is this size today but if we're smart and we use all of the skill sets that we're learning here we have a better idea of what that future economic output is going to look like which then makes us more efficient financial analysts and you'll see that as we go through these learning outcomes statements so look at that first one factors favoring and limiting economic growth long run rate of stock market appreciation potential gdp forecast potential gdp and then the institute throws a really interesting section in there on natural resources and uh population and then we'll end with a brief conversation on trade barriers but there's probably an important one in there notice the second bullet point there on losses compare classical neoclassical and endogenous growth theories i think that's going to be an important one as we go through but also note that technology the word technology appears in a lot of these losses and you'll see you'll see what i mean here in just a second oh my gosh there's another technology right in the middle of this uh this slide so a brief recap economic growth is the increase in the production of goods and services of a country over a specific time all right that's the economist language for what i was saying earlier is that these companies out there are finding positive net present value projects at the micro level and when you aggregate all those micro level increases in positive net present values you get economic growth indicators of economic growth right the amount of stuff out there there's a picture of a dump truck that's a good one technology human capital you know i always think of human capital when i look at my children as their brains and as their brains develop you know when they're when they were little they had you know these little teeny-weeny brains they couldn't really do a whole lot and as they grew they they increased their capacity for decision-making and wisdom and all that kind of stuff i'm sure those of you who are parents uh can understand uh the importance of the increase in human capital the ability to to solve a problem you know when my children come to me and say something like hey dad what's going on i say well i can help you but why don't you figure it out you know the old figure it out is really a great parenting strategy of course sometimes my sons make decisions where i think their brains are about the size of a p and then growth in labor force over there so this is probably a good recap from what you learned back in level one so let's go ahead and start with this first super simple loss factors favoring and limiting economic growth these couple of slides i'm going to call hey i bet you remember this because this is super common sense rate of savings that makes sense financial markets right poorly developed financial markets limit growth uh legal systems yeah property rights and uh let me just remind you that you know we have thomas jefferson to thank for these well-defined property rights here in the united states thomas jefferson and i'm i'm paraphrasing here he said something like you know this republic has no chance of success if we don't recognize property rights and then enforce them in the court of laws education and health services that makes super important sense especially here as we move through this period of covet and we're trying to figure out exactly what health services mean and who has access to health services and vaccinations and recoveries and all that kind of stuff i like this third one there policies regarding entrepreneurship mean absolutely that economic growth is fueled by here let me just go back here let me go back here to that third one an increase in human capital so we have let's just take my one of my sons for example who's gone from a p brain to i mean this amazing young man um and so it's it's it's the ideas that are young it doesn't have to be young but our are adults and it could be kids as well who who have this idea and they say you know what i want to pursue this idea because it's going to help us out this of course uh this of course can increase economic growth and then free trade this was a big topic during the trump presidency about uh you know do we do we have these tariffs do we not have these tariffs do we strict restrict capital flows do we not from certain countries countries etc etc now this is my personal favorite los because this is the los that says something like okay jim this is pretty much what you teach in all of your classes i go like this into in my class all the time i say here's the economy it can go like this or it can go like this what we're trying to figure out is the relationship between stock market appreciation and and what kind of economy we have the author of this reading calls it a sustainable growth rate so we have to worry about growing too fast and then we hit the specter of inflation which is a big concern summer sometime here in 2021.

[00:07:37]let me go ahead and define this make sure you understand potential gdp is the maximum output of an economy that can sustainably generate without causing an increase in inflation so that's really an interesting sentence especially because there are so many different ways to measure inflation and there are probably a couple of different ways to measure uh gdp but anyway you get this sense that okay we want to grow at this potential gdp so that our purchasing power oh man didn't we talk about purchasing power parity in a in a recent recording so that our purchasing power is maintained over time right we don't want to we don't want to work really hard for a year and then go shopping and not be able to buy anything right we want to be able to buy stuff at the end of the year that's more than than what we had at the beginning of the year now look at that third circle point stock market performance depends on the performance of the economy boy i love that sentence there and i teach the students in my investments class and we'll talk at length about this throughout level two is that you know you have this well-diversified portfolio which means that investors they tend not always but they tend to virtually eliminate unsystematic risk which means that the only thing left is systematic risk and let me just remind you systematic risk is defined as the variability in returns due to changes in economic factors and so i tell my students i say look when you go out and invest in a well-diversified portfolio you're betting on economic growth and then of course you're betting that the executives on your in your portfolio are going to be able to capture that positive net present value that's out there now economists they love to use some kind of equations to describe the thoughts that go around in their brains and those of you who are really good at algebra will look at this relationship and you'll see a gdp in the numerator and a denominator and an e in the numerator and the denominator and you may just mentally cross those out and you'll say wait a minute jim this relationship is just p is equal to p and of course that's true but this is the way economists think and just let me remind you that during my phd program i i do have a minor in economics so i had a bunch of economics classes and so you learn about this way of thinking and it's really really awesome because what we're doing is not really saying p equals p we're rake we're breaking down what that p means right the aggregate value of equity securities is a function of a handful of variables so let's start with the red gdp so there's the size of the economy that makes sense based on what we've talked about earlier and then in green e over gdp that's some kind of an earnings yield right some kind of a yield and that's in green so think of the green as kind of a return on gdp and then over in the purple we have a multiple right price earnings ratio so the aggregate value value of equities and remember this is what we're trying to do as good financial analysts is determine what those future stock prices are going to be and so this really simple uh equation tells us that it's a function of the economy it's a function of the efficiency of the economy right aggregate earnings over gdp and then some kind of a price multiple and i know i've said this to you before but i think it's worth repeating that i always think of the p e ratio as hey what's going on on the floor of the new york stock exchange right a dollar of earnings is costing investors how much in price so super high p e ratios tell us that the investors believe that that stock price is super valuable and so they're willing to pay for it now what you can do you can take this equation and turn it into a return relationship using uh some logarithms and i won't show you that equation even though they the the reading shows it to you but it's not that too terribly important but what we're saying here is that if we go back to this relationship here percentage change in price on the left-hand side of the equal sign is a function of the percentage change in gdp the percentage change in some kind of an earnings yield right the reading calls it corporate earnings share of gdp and then a percentage change in price to earnings ratio and that's probably not at the individual stock level but at the but at the market level now look at our bullet points over on the right over the short term stock market performance is affected by all three factors so this is super important here describe that relationship i really like that now even though the los says long run rate of stock market appreciation you need to know how important this is in the short term because then what happens in the long term is that the potential gdp growth rate is probably going to equal that rate of aggregate equity valuation and let me show you a little bit more about what i mean there when we go to this next loss explain why potential gdp and its growth rate matter for equity and fixed income investors all right so gdp is important because it controls the effects of inflation in the economy right if the economy is going like this then central banks here in the united states the fed is going to say something like okay we love economic growth but we don't love super high economic growth because there are consequences to it right marginal costs and marginal benefits and so look at the second diamond point when the actual gdp exceeds the potential gdp then we're necessarily going to have inflation which necessarily means that interest rates are going to rise which necessarily means that bond prices are going to fall all right so that's super important let's see are are any of you old enough to remember the 1970s when we had in the united states you know 16 or 18 inflation so we had you know lots of inflation lots of interest rates and and bond prices falling but then here look at that that indented diamond point central bank will most likely impose a restrictive monetary policy which then means that if we're restricting monetary policy that's probably going to have a negative impact on stock prices now on the other hand notice we put this in red high potential gdp growth results in high real interest rates and higher expected real asset returns which means then that there's probably going to be an increase in gdp over time remember we're not having inflation here and that will most likely result in lowering of things like default risk so the reading calls that improving the credit quality of fixed income securities in which case bond prices will rise so that takes care of that part of the loss about about growth rates and fixed income investors but then let's go ahead and summarize the impact on equity investors and we took something directly from the reading here there was a a study that was cited between 1946 and 2007 and it noted that our equity price appreciation so the aggregate increase in prices during that you know what is that 60-year period or so was almost exactly equal to about the seven percent growth rate of u.s nominal gdp so that's important so let me go back to this one here so over the short term those three factors are important but over the long term it really comes down to u.s nominal gdp growth according according to this this particular study but also according to the very beginning of this reading and that makes sense and that's consistent with of course what i teach my students that when they owned a well-diversified portfolio they're really betting on the economy all right so let's move on to uh determinants of economic growth so we go to this cobb douglas production function for aggregate output that's why and it's a function of capital and labor those of you been paying attention to my recordings over the years will note that i love to give examples of my personal history and so i when i was in early college i worked in i worked in a donut factory and i learned first hand that if you had better machines and more efficient machines and even more machinery then we could make more donuts and then i learned that if you have more employees and better employees and more motivated employees we could make more donuts but of course there's marginal diminishing marginal productivity for both of these right our factory was fixed in size so if you put a thousand machines in there nobody can work them or if you put a thousand workers in there nobody has any elbow room to get anything done so of course we like a production function to be reflective of capital and labor and then we can put it in that far right to the equal sign format where we're raising k to alpha and l to 1 minus alpha of course alpha is the share of gdp allocated to capital think of that think of that as kind of a return to the providers of capital think of it as the return to the shareholders now it's not it's not exact one one-to-one relationship it's the return on the physical machinery but of course it's the bondholders and the shareholders that have provided the capital to buy that machinery and then of course one minus alpha is the return to labor uh we're assuming constant returns to scale which means if we increase input we increase output but there's diminishing marginal productivity in there all right so let's go on to the next loss here about capital deepening and technological process so i said to you earlier that technology is an important word here so think of this uh total factor productivity as the productivity or the technology level of an economy and that technological process progress then is the economy's ability to produce more output without throwing more donut machines and without throwing more workers like me into the factory but we can now have one machine that does the work of of three machines boy that sounds to me like technology technological process progress uh capital deepening is the increase in the economy stock relative to its workforce all right so this is shown by an increase in the capital to labor ratio what happens is that it can increase output but probably is not going to lead to any increase in sustained economic growth now i love this uh i love this illustration this graph there's a lot of those graphs in my economics days that i didn't like but this one here is really good so i like this i like this productivity so think of these as production functions or the production frontier and so capital deepening is going to be a movement along the production function remember we could move along the demand curve back in level one well that's similar to what we're doing here and notice that capital deepening this is good news right so we're moving from let's say a to b and it's upward sloping however technological progress is a different level we're moving to a higher plane we're moving up to c so not only is there a dramatic increase in productivity but now we have a steeper slope so at the margins we're going to be able to make more progress so i think that's important they're distinguished between capital deepening and the progress so remember deepening movement along production function but the technological progress is an absolute jump it's a shift in that production production function so yes of course we want to deepen capital uh but if we can if we can have one machine do what three machines do that's way better than going from one machine to two machines by the way i was not a very good donut maker back when i was in my early college days all right how about growth accounting relations so sources of growth growth and labor growth in capital and growth in technological progress all right so this is summarized by this guy solo's growth accounting equation in which we're going to say something like we're going we want to have this growth in technology that's the a then growth in capital and then growth in labor now that looks like an awful lot like a relatively complexifying equation but it's really not so let's go ahead let me just show you a real quick example of what the institute might do on the exam because look forecast potential gdp using this model so this is what we're going to have to do so here we go question stem gives us labor costs 55 percent labor growth two percent capital investment two percent and tfp two and a half percent potential growth rate is closest to so you really just extract those inputs from the question stem throw them into the equation and you end up with 5.4 percent all right so let's just take a deep breath before we move on here this is important right what are we trying to do as good financial analysts we're trying to deliver some type of a service to our clients whatever that service is in order for us to be able to do this we need to think like an economist and we need to be able to forecast potential gdp growth rates now the uses of this growth rate equation contributions sources of growth and potential gdp so that's pretty much a summary of what i was describing back here but let's go ahead and move on to a labor productivity growth accounting equation and this one you'll just love because it's boy look at the advantage it's simple and disadvantage is because it's simple i'm not quite sure what it means let me just show you here we have labor force growth rate productivity growth rate so what could be easier than four plus six ten percent growth rate so uh be able to go back here and use a little bit of multiplication and adding this was the solos growth accounting equation and then be able to use this labor productivity growth accounting equation this is what i was saying earlier in that in the slide deck about the the impact of natural resources on economic growth and this makes perfect sense i mean here in the united states right what do we what do we have we have a lot of stuff under the ground and we have beautiful soil so that we can grow stuff above the ground and not a lot of countries throughout the world have the land mass that we do here in the united states and the soil quality and all of the stuff that's under the ground and so that's probably relatively important regarding adding natural resources into a model of economic growth so human capital raw material raw materials public capital quantity of labor technological know-how ict information computer and telecommunications and then non-ict so there's a good old mathematically expressed equation down at the bottom so the next part of the reading then describes the categories of natural resources so renewable and non-renewable i'm guessing that you don't need me to go through and explain those because of course in the last 20 or 30 years this has been a super hot topic not just in the united states but outside outside and including the entire globe a couple of important things to take away from this slide so look at the first diamond point countries with more natural resources more likely to experience high economic growth however this doesn't always have to be the case some uh countries that have lots of natural resources may have some restrictions maybe they're natural maybe there are unnatural restrictions that prevents them from achieving high economic growth rates but those countries that are resource poor they can always they can always trade so look at that last diamond point there access to natural resources is crucial for economic growth either through the development inside of the borders or trading outside of the borders yeah there's this concept of a dutch disease as an economic term uh describes the simple fact that domestic currency can appreciate because this country has so much natural resources so they're exporting you know think uh think of a country that's rich in trees you know so they're cutting these trees down and exporting lumber and so this is a good thing but then what happens is that the rest of the economy suffers and i can't help but think uh about my favorite country and my favorite example back in 2008 financial crisis of iceland when you know iceland for thousands and thousands of years have pretty much been uh been fishermen and fisher women and so all of a sudden they decided to become bankers and uh you guys know what happened in the 2008 financial crisis if you don't know what happened to iceland back then it's it's really a fascinating story one day the government showed up for work and said we're not doing anything and they had to be bailed out i think was the imf that bailed him out but look at this dutch disease ending there becoming globally uncompetitive all right so this is a problem what does that diamond point say the presence of natural material in some countries may restrain economic growth uh labor force okay what do we know about labor force and sustainability of economic growth of course if you have more people then you're likely to have growth in the economy how about some labor supply factors here this is another series of slide decks that i'm going to call just regular old common sense so demographics right younger populations countries have higher potential growth that makes perfect sense labor force participation this was a big deal in the united states during the george bush presidency and then the barack obama presidency and then and then the donald trump presidency this labor force participation rate sometimes it was going up sometimes it was going down you know during the uh joe biden presidency there hasn't been much talk about this you know probably because of covet immigration boy this is a huge issue in the united states uh and average hours worked here's another one of our good slides that i would recommend go ahead and take your phone out and take a picture of this and have it available to yourself factors influencing economic growth this is a good summary of what we've talked about here physical capital human capital technology and then added is the purple down on the right public infrastructure and so of course we need roads and bridges and municipalities to be run efficiently and i like that last circle point improves the productivity of private investments all right so let's take a look at some some theories of growth let's look at this classical model that goes all the way back to 1800 i believe in which notice the diamond point i'm sorry the arrow point i have over on the over on the right production function is a in the classical model is simple and it consists of a labor input so you have me working in the factory but there's no factory in 1800 there's just land and land is a fixed factor it is a fixed factor so this classical model remember this is and it's classical which means that it's not recent and so think about 1800 and think about what life was like in whatever country that you're living in right now what was life like in 1800 far different than it was far far different than it is today but some important parts of this model that we can use of course we can use this to build on newer models so this model suggests that real gdp growth is really just temporary when the when the real gdp per person growth rate increases then a population explosion will bring it back to a subsistence level all right so this is what this uh malthusian theory was based on the ideas back in 1800 that if population surge there's going to be too many people so look at the third bullet point an increase in population negatively affects economic growth hmm at the last one standard of living remains unchanged even with technological development so now look at what we put down there at the bottom in smaller font size it fails for a variety of reasons that we just described but from an economic standpoint and this might be a really good exam question because technological progress has exceeded in almost all cases the impact of those diminishing marginal returns that we've talked about throughout the slide deck all right so this model fails for a variety of reasons which means then that there's probably something that came after it so the neoclassical model goes back to the late 1950s economic growth and growth in real gdp depend on exogenous technological progress all right so this is important remember exo means outside so progress that occurs from a technology standpoint out there is going to be pooled in to the economy and then we're going to experience this economic growth so look at that fourth circle point long run growth rate per capita is related to the rate of progress right population growth so even this neoclassical model relies on this idea about population and population changes and then it adds of course a savings or investment rate and that's super important addition to this model because of course of course companies are not going to have access to capital unless you or i save now when we save that might mean we go down to a bank or it might mean that we buy shares of stock in johnson and johnson let's say 20 years ago and now in 2020 johnson johnson has a covet vaccine so see how the savings 20 years ago and then the technology improvements over time and then boom we have something here and this vaccine in 2021 has allowed the economy to continue to grow now this neoclassical model look at the last circle point there per capita incomes of developing and developed countries converge over time so that's an important part i'm going to come back to that here in just uh in just a minute but let's go ahead and take care of this endogenous growth theory now remember endogenous means you know origination from within so that instead of us pulling the technology in from the outside world what we're going to do is develop it or evolve it inside so look at the two indented bullet points right depends on the ability and willingness of people to innovate oh my gosh so what do we have and this is true not just in the united states but throughout the world the ability and the willingness of people to innovate i mean this is just this is this is what drives this is what drives the free enterprise system i saw a great example of this in the uh 2020 a summer olympics which occurred of course occurred in 2021 uh there was a uh an athlete who was some type of a gymnast when she was little and some type of something else and she had a uh she was she had a displaced hip and so she got in a canoe and she won a gold medal in a canoe because she had this problem and so this uh the ability and willingness of people to innovate of course humans have a natural ability and willingness you know to figure stuff out so increase in population positively affects economic growth so that's an important one look at that los compare these so that's an important comparison and then also this function represents a straight line unlike the neoclassical production function which is a curve so let's get back to this idea of convergence it's the idea that developing countries can catch up so we can absolutely have absolute convergence in which they absolutely converge we can have conditional convergence in which convergence depends or is conditional upon some things that go on in the economy like this absolute convergent convergence kinds of mean it kind of means that oh those countries over there they'll just catch up because they'll figure stuff out by watching us right and we'll help them out we're happy to help them out and they'll just catch up but now this conditional convergence tells us that boy inside of the economy we need some conditions to hold true in order for those countries to catch up to develop to develop countries and so look at those examples equal savings rates population and production function that's probably the most important club convergence this is an interesting kind of a scenario it tells us that boy there are different levels of developed countries and so there's convergence between probably the rich countries and the middle income countries they'll converge but the poorer countries probably are left out they will not converge and so this is the non-convergence trap these countries are not in the club whatever whatever that club theory means now how does convergence occur well this should make perfect sense deepening and accumulation adoption of technology so this is what we talked about just a handful slides ago is that those poor countries those developing countries they need they need capital deepening they need capital accumulation and they need technology and so there's a there's a good old illustration of you know look at look at the relationship between oh just pick the bottom two you know germany and canada you could probably say you know they look pretty similar right if not if not virtually identical and then look at new zealand and japan you know they're somewhere around so you could see convergence going on there but look at kenya and india and ethiopia clearly during that 20-year period there's not a convergence now of course we can't have a conversation about the economy without saying okay there are entrepreneurs there are innovators there are financial analysts there are executives who invest in positive net present value projects we can't have this conversation because by ignoring that other entity that's out there governments right so how can governments what role is there for governments to play to provide incentives so this loss reads provide incentives you know promote startup of new businesses right encourage existing firms to expand and discouraging firms from moving to other countries boy that's an interesting one um so all the stuff that we've talked about that are important in terms of labor and capital the government ought to come up with incentives to promote growth rates in capital growth rates and labor force so that and look what's important down there and what is that the third diamond point provision of incentives by governments for spending on r and d all right so this is exactly what i was talking about with johnson and johnson it's not true just with the covid vaccine but it's true with all sorts of research and development and it could be something as simple as r d on how jim can make a better doughnut i i think i consumed more donuts while i was working there than i actually made all right here's a super simple slide growth in an open economy trade and finance and cash flows freely right open and trade oriented economies grow much faster than closed economies impact oops sorry about that let's go ahead and do this last one here impact of an open economy on economic growth i bet i bet we know this based on not only the things that we've talked about just today but just regular old knowledge of reading the wall street journal and taking taking classes over our lifetimes so countries can adopt technology right international trade increases competition access to international market is important oh boy let's not restrict domestic savings companies can allocate resources yeah i love this one i'm a great uh uh asset allocator and so what we need to do is make sure that we specialize in those industries in the in which we have an expertise and so i think that takes us through uh this reading once again i would say that all of those losses that have the three letters gdp in them are probably uh the most important because from a test creating standpoint i'm guessing that the cfa institute is interested in us not becoming economists but thinking like an economist so that we can help solve an investment problem and solving that investment problem includes being able to not only understand gdp and the economy but be able to forecast gdp [Music] you