[MUSIC] To end this lesson, let's flip things around and look at discretionary monetary policy from the perspective of both business executives and money managers. [MUSIC] The underlying key concept here is this. [MUSIC] When a central bank engages in monetary policy, it is by definition seeking to influence two of the most important parameters for doing business and investing in a global economy. [MUSIC] Level of interest rates and currency exchange rates. It follows from this observation that both business executives and money managers can profit by keeping a close watch on how central banks around the world are responding to changing macro economic conditions with their discretionary monetary policies. To give this abstraction a bit of real world flavor, consider these scenarios and examples that illustrate in more detail how to strategically manage movements of the business cycle. [MUSIC] Suppose now you are the chief financial officer of a company operating in a bricks and mortar, highly capital-intensive industry, such as steel production. And suppose further, that in an era of low interest rates, you have chosen to finance much of your company's new capital construction programs with relatively cheap short term debt, rather than long term debt. So your ratio of short-to-long term debt is relatively high by industry standards. [MUSIC] Now looking at the macroeconomic chessboard, you see both the Consumer Price Index and Producer Price Index trending up. That's indicating that inflation may now be accelerating. You've also read in the newspaper that the Central Bank has begun to debate whether it should start hiking interest rates to control that inflation. At this point, here's the question. Should you load up on even more short-term debt, at an interest rate of 5%, before the party is over when the central bank starts hiking interest rates, or should you begin to roll your short-term debt into longer-term debt with a fixed interest rate of 7%? Take a minute now to think about this, and then jot down your answer and its rationale. [MUSIC] The answer here is you should definitely begin to roll over your short-term debt into longer term debt instruments. Just why is this so? Well even though you may pay a bit more in higher interest rates, for the longer term debt, you will nonetheless be able to lock in a lower rate over time should inflation continue to accelerate and interest rates significantly rise. For example, if inflation does spike, short-term interest rates could quickly rise to 8% or 10% or higher, but you've already locked in that long term rate of 7% in anticipation of that interest rate spike. Your company will therefore be more profitable. [MUSIC] Suppose now you are the Chief Executive Officer of a chain of automobile dealerships in your country. You specialize in selling luxury foreign imports including BMWs from Germany and the Lexus line from Japan. Suppose further that over the next year, you believe the economy is going to slowdown dramatically and put downward pressure on the inflation rate. How do you think the central bank in your country might react to this recessionary and deflationary trend? And what kinds of risk might the Central Bank's actions pose to your bottom line? More importantly, what strategic steps might you take to ensure continued profitability in what looks to be a rough year ahead? Take a minute now to jot down some ideas before moving on. [MUSIC] Okay this is a pretty complicated question, it's also a fun one. Basically the most obvious risk you face is the possibility that slow growth in recession will lead to reduced demand for the cars you're selling to customers at your dealerships. In fact, the automobile industry is one of the most highly cyclical industries in any nation and the first to feel the effects of a recession. To deal with this particular risk, one key step you can certainly take is to reduce your inventories so you don't wind up with too many cars stuck on the lot, too few customers to sell the cars to. There is, however, a far less obvious, but equally troublesome risk you face as a seller of imported cars. Reform of what's called exchange rate risk. The problem here is that if your government's central bank responds to the onset of slow growth or recession with a significant cut in interest rates, such a fall in interest rates will likely weaken the domestic currency, as we've learned. This cheaper currency will, in turn, make it more expensive for your company to import the cars it buys at wholesale from Germany and Japan for selling at retail for your customer. And even if you continue to sell your cars at a brisk pace, an unlikely outcome if a recession comes, your profit margin is likely to be squeezed by the higher import costs. [MUSIC] As for what you can strategically do here, one possible step would be to hedge your exchange rate risk in the currency futures market. In fact, you could buy currency futures that will allow you to offset any depreciation in the domestic currency. And note, such a hedging strategy is not just for. It maybe useful for any business that relies on the importation of foreign goods for resell in the domestic economy. And also note that 'm just throwing some very big ideas at you by talking about concepts like hedging, currency futures. If you get a little extra time, you may want to cruise the internet to explore these ideas more fully. For now, here's another example. [MUSIC] Now what about the opposite situation, where your car dealership is not selling any foreign imports at all. It nearly sells domestic brands. If you see a recession coming and around of interest rates cuts by the central banks, along with a weakening of the domestic currency, what might you do strategically in the realm of advertising, marketing and inventory management. Think about that for a minute, and maybe jot down some ideas before moving on. [MUSIC] Well, in this case, you will likely do the same thing as your foreign import competitor and start cutting inventories in anticipation of the slow. However, you may also want to shift the product mix of cars that you will be selling on your lot. The idea here is that you're in a recession. People are going to be more price sensitive. Or, as they say in micro economics, the man will become more elastic. That means you will be better off selling lower priced cars, and fewer features at value, oriented prices. But here's something else you will also be able to do. You can run an aggressive marketing campaign to try and grab market share from the foreign import segment of the market. The key idea here is that your foreign car competitor should be under rising price pressures from the weakening domestic currency. In such an environment, you should be able to much more aggressively compete on prices against these foreign import dealers. That's a great example of strategic business cycle management driven by your knowledge of monetary policy and its effects. [MUSIC] Now, what if you are an investment advisor or money manager? Why is it important to keep your eye on monetary policy? Well suppose as a money manager you have a client with $10,000,000 who has instructed you to always keep part of her money in the stock market and part of the money in the bond market. However, a client also allows you to change the allocation between stocks and bonds in response to changing market and macroeconomic conditions. Now, further suppose you've been watching the economy closely. You've noticed a deterioration in a number of economic indicators. And you think that a recession is on the horizon that will lead to the Central Banks in both the United States and Europe to start cutting interest rates soon as part of an expansionary monetary policy stimulus. Your view of the chessboard. What will be your asset allocation strategy? Specifically, will you increase the weight of stocks in your clients portfolio, and decrease the weight of bonds, or do just the opposite, buy more bonds and reduce your client's stock holdings. Take a minute now to think this asset allocation problem through and jot down your answer. And with your answer also explain just why you're favoring stocks over bonds or bonds over stocks in this scenario. [MUSIC] So what do you do if you're anticipating a recession, and a round of interest rate cuts by the US Federal Reserve and the European Central Bank? Well, you will definitely weight your client's portfolio significantly more towards bonds, by buying more bonds and selling some of the stocks in that portfolio. So why will you do that? Well, all stock prices reflect as an expectation of a future stream of earnings by a company. And if recession is coming, that will reduce business activity, revenues and the earnings in most companies. This in turn means that stock prices are likely to fall as more investors sell their stocks in expectation of these reduced earnings. Let's rewind and load up on bonds, this is a bit trickier. The key thing you have to remember here is that bond prices and bond yields are inversely related. That means as interest rates fall, say in a recession, when the central bank is cutting interest rates, bond yields will also fall while bond prices will go up. So, if you buy bonds with the expectations of a recession and a recession comes, pricing your bonds will rise and you will make a profit. And by the way, when you do this, what you are essentially doing is locking in a higher yield on your bond portfolio before the recession comes and yields fall. [MUSIC] Okay, those last examples were a bit complicated. But, hey, he's trying to get you ready for the real world of business and finance. And also get you thinking really hard about how macroeconomics really affects much of what you do. So take a breather now and get some rest. You have certainly earned it and I'll see you again soon. The Merage School of Business at the University of California, Irvine, I'm Peter Navarro. [MUSIC]
