Reading 23: Capital Market Expectations－LOS g estate, equity, returns, business

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CFA Institute Area 6: Economics
Session 6: Economic Concepts for Asset Valuation in Portfolio Management
Reading 23: Capital Market Expectations
LOS g: Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns.

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Which of the following statements regarding spending and the business cycle is least accurate?

A) As a percentage of GDP, consumer spending is much larger than business spending.

B) The inventory cycle is shorter than the business cycle.

C) Central banks prefer a low level of inflation to the prospect of deflation.

D) Business spending is less volatile than consumer spending.

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Answer and Explanation

Business spending is more volatile than consumer spending. Spending by businesses on inventory and investments are quite volatile over the business cycle. As a percentage of GDP, consumer spending is much larger than business spending. The inventory cycle typically lasts two to four years whereas the business cycle has a typical duration of nine to eleven years. Deflation results in interest rates near zero, so the central bank cannot lower rates any further to stimulate the economy. For this reason, central banks prefer a low level of inflation to the prospect of deflation.

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Which inflation rate would allow for the greatest consistent long term growth of equity value?

A) 5%.

B) 3%.

C) 2%.

D) 8%.

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Answer and Explanation

Low inflation can be a positive for equities given that there are prospects for economic growth free of central bank interference. Inflation rates above three percent can be negative though because it increases the likelihood that the central bank will restrict economic growth. Declining inflation or deflation is also problematic because this usually results in declining economic growth and asset prices. The firms most affected are those that are highly levered. They would face declining profits yet would still be obligated to pay back the same amount in interest and principal.