NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-7

Session-13

Economic Analysis – I
Outline
• Fundamental Analysis
• Macroeconomic Variables
• Demand and Supply Shocks
• Monetary and Fiscal Policy

Fundamental Analysis

For estimating the price of a stock, the security analyst must forecast the earnings and cash flows that can
be expected from the firm. This is primarily known as fundamental analysis. The performance of a
particular stock or company is affected – rather determined – by numerous factors associated with
economy, industry and the company itself. That is why fundamental analysis is also known as economy-
industry-company [EIC] analysis. Module – 7 is devoted to economic analysis. Subsequent modules deal
with industry and company analysis.

Economic Analysis

A particular firm or company is a micro unit of the economy as a whole. Fluctuations in security markets
are related to changes in expectations for the aggregate economy. Prospects of the firms are tied to those
of the broader economy even that of international economy. For some firms, macroeconomic and industry
circumstances might have a greater influence on profits and cash flows that the firm’s relative
performance within its industry.

Global Economy: The economic analysis should start from the global economy. Since the economies are
interrelated – thus the firms across economies, the international economy can affect a firm’s prospects. It
affects the price competition it faces from competitors, or the profits it makes on investments abroad. At a
particular point of time, there can be variations in the economic performance across countries. Similarly,
political risks can be of greater magnitude in other countries compared to domestic political environment.
Fluctuations in currency exchange rate also affect the performance of companies. Figure 13.1 depicts the
real GDP growth of developed and emerging economies. One can see that trend is not always similar and
the pattern in rate of growth is also different. The emerging economies show higher growth in comparison
to developed economies. One need not be surprised about attraction of investors towards emerging

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economies. If explored further, different countries in a particular group [emerging or developed] would
also show varied GDP growth and pattern.

Figure: 13.1: Real GDP Growth – Developed Vs. Emerging Economies

Source: Global Finance Magazine

Domestic Macro Economy: An analyst should be able to forecast about domestic macro economy better
than other analysts. By this, the analyst [for that matter, a fund manager] can outsmart the peers in
showing investment performance. The key macroeconomic variables that an analyst should look at are:

• Gross Domestic Product: Measure of the economy’s total production of goods and services.
Growth in GDP reflects opportunities for a firm to increase its revenue by selling more products
or services.
• Industrial Growth Rate: Although part of GDP growth, industry growth rates indicates the activity
in manufacturing sector of the economy.
• Monsoon and Agriculture: For agrarian economies these two factors are pertinent. Several
industries also depend on agriculture for inputs. Level of monsoon indicates the likely
performance of agriculture sector.
• Employment and Capacity Utilization: The employment of labour as well as other factors of
production [like machine capacity] indicates the level of economic activity in the country.
• Price Level and Inflation: The general level of price rise is known as inflation. When demand for
products and services are higher than the productive capacity, there can be high inflation. The
governments and monetary regulators like Reserve Bank of India try to draw a balance between
inflation, growth and unemployment.
• Interest Rates: Sectors like consumer durables, automobiles and housing are highly sensitive to
interest rates. High interest rates also reduce the present value of investment.

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 • Budget Deficit: This is the difference between government spending and revenues. The shortfall
is taken care by government borrowing. Government borrowing can impact interest rates as well
as restrict the private sector borrowings from market.
• Sentiment: Depending upon the level of confidence of consumers in future income levels, they
will like to spend more in future which in turn affects the confidence of producers. Accordingly
producers plan their investment activity.

Figure 13.2 shows the trend in GDP in India vs. BSE Sensex. One can see that from 2002-03 till 2007-08,
BSE Sensex has moved in tandem with GDP.

Figure: 13.2: BSE Sensex and GDP of India

6,000,000 18000
GDP at Market Price (Rs.

16000
5,000,000
14000

BSE Sensex
4,000,000 12000
Crore)

10000
3,000,000
8000
2,000,000 6000
4000
1,000,000
2000
- 0

GDP at Market Price BSE Sensex

Analysing Macro Economy - Demand and Supply Shocks: The different factors that affect the macro
economy can broadly be considered as demand and supply shocks. Demand shocks are the events that
affect the demand for goods and services in the economy. Demand shocks are characterized by aggregate
output moving in the same direction as interest rates and inflation. For example, reduction in tax rates can
increase the disposable income of the consumers. This is expected to increase the demand for products
and services, which in turn can lead to increase in inflation. The events that influence production capacity
and costs are known as supply shocks. Supply shocks are usually characterized by aggregate output
moving in the opposite direction of inflation and interest rates. Natural calamity can adversely affect the
production in the economy, thus reducing the aggregate output and increase in the cost of production and
output. Consumers will not be willing to purchase the outputs at higher prices. Overall GDP is likely to
fall. Some of the examples of demand and supply shocks are given below. Analysts need to identify
industries based on the demand and supply conditions and devise the switching strategy [from one
industry to another]

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 Demand Shocks Supply Shocks
• Reduction in Tax rates • Natural calamity
• Increase in money supply • Changes in educational level of workforce
• Increases in government spending • Changes in the wage rates
• Changes in the price of imported oil
Source: Bodie et al (2009)

Government Policy: Governments and monetary authorities devise policies affecting both demand and
supply conditions in the economy.

Demand-side Policies are expected to stimulate the total demand for goods and services. The two major
demand-side policies are fiscal and monetary policies. Fiscal policy denotes the spending and tax actions
of the government and is part of demand-side management. Government has to strike the delicate balance
between political condition and economic stability. Government may hesitate in curtailing the spending in
social sector because of electoral compulsion. Increase in tax rates can decrease the disposable income of
the consumers. But the increased tax collection can facilitate greater spending by the government for the
economy. Without appropriate tax collection, the deficit will increase thus leading to borrowing by the
government. Monetary policy intends to regulate the money supply to affect the macroeconomy.
Primarily the effect of monetary policy is seen in terms of change in interest rate. Expansionary monetary
policy lowers the interest rate and stimulates investment and consumption demand in short run. But it can
also lead to higher prices, thus inflation in long run. Fiscal policy is designed by the government while
monetary policy is designed and implemented by the monetary authority i.e. the central bank of the
country.

In conclusion, it is imperative for the investors and analysts to devise models to forecast the market and
take investment decision or tweak the existing investments. In the second part of the module on Economic
Analysis, we shall discuss the tools for economic forecasting focussing more on the business cycle,
economic indicators, indices etc.

References:

Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage)
Learning, New Delhi
Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi
Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New
Delhi

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Questions and Answers

Q.1.: What is fundamental analysis and what are the major components of the same?

Ans.: For estimating the price of a stock, the security analyst must forecast the earnings and cash flows
that can be expected from the firm. This is primarily known as fundamental analysis. Fundamental
analysis – also known as EIC analysis – comprises of:

 Economic Analysis
 Industry Analysis
 Company Analysis

Q.2.: What are the key domestic economic variables to be considered for economic analysis?

Ans.: The following domestic economic variables need to be considered for economic analysis.

 Gross Domestic Product

 Industrial Growth Rate
 Monsoon and Agriculture
 Employment and Capacity Utilization
 Price Level and Inflation
 Interest Rates
 Budget Deficit
 Sentiment: Consumers’ and producers’ optimism or pessimism

Q.3.: What is meant by demand shocks and what are different methods of demand shocks?

Ans.: Demand Shocks: an event that affects the demand for goods and services in the economy. Demand
shocks are characterized by aggregate output moving in the same direction as interest rates and inflation.
Different methods of demand shocks are:

 Reduction in Tax rates

 Increase in money supply
 Increases in government spending

Q.4.: What is meant by demand shocks and what are different methods of demand shocks?

Supply Shocks are events that influence production capacity and costs. Supply shocks are usually
characterized by aggregate output moving in the opposite direction of inflation and interest rates. Some of
the examples of supply shocks are:

 Natural calamity
 Changes in educational level of workforce
 Changes in the wage rates
 Changes in the price of imported oil