Page 20 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 12.b: Describe the relation between the long-run rate of
stock market appreciation and the sustainable growth rate of READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
the economy.

MODULE 12.1: GROWTH FACTORS AND PRODUCTION FUNCTION

The potential GDP of a country—is an important factor in predicting returns on aggregate equity markets.
Can be modelled as: ΔP = ΔGDP + Δ(E/GDP) + Δ(P/E)

Growth in aggregate stock market valuation linked to GDP growth, growth in earnings relative to GDP, and growth in the price to
earnings ratio.

Long long-term, earnings growth relative to GDP = 0 because labor will be unwilling to accept an ever decreasing share of GDP.

Similarly, growth in the P/E ratio = 0 because investors will not continue to pay an ever increasing price for the same level of
earnings forever (i.e., the P/E ratio cannot grow indefinitely). Hence over a sufficiently long time horizon, the potential GDP growth
rate equals the growth rate of aggregate equity valuation.

LOS 12.c: Explain why potential GDP and its growth rate matter for equity and fixed income investors.

Apart from growth in potential GDP being the main driver of aggregate equity valuation, it also has implications for real interest rates.

• + growth in potential GDP indicates future income will rise relative to current, current C will rise and current S will drop. To encourage S,
investments would have to offer a higher real rate of return; hence higher real interest rates and higher real asset returns in general.

Short term, the relationship between actual GDP and potential GDP provides insight as to the state of the economy.

• Anticipate inflationary pressures: For example, an excess of actual GDP over potential GDP results in rising prices; we can use this
gap as a forecast of inflationary pressures—useful to all investors but of particular concern to fixed-income investors.
• Predict monetary policy: Furthermore, central banks are likely to adopt MP consistent with this gap –the resulting inflationary concerns
means central bank is more likely to follow a restrictive monetary policy (and vice versa).
• Predict fiscal policy: Government is more likely to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate.
• Assess credit risks: Because of the credit risk assumed by fixed-income investors, growth in GDP may be used to gauge credit risk of
both corporate and government debt. A higher potential GDP growth rate reduces expected credit risk and generally increases the credit
quality of all debt issues.