Economic Patterns with Staying Power Roger Brinner Partner and Chief Economist The Parthenon Group October 21, 2003 200 State Street, Boston, MA 02109
Economic Patterns with Staying Power Basic Macro-economic Forces Consumer Attitudes and Reactions The Fed and Investors Indeed, Even High-Tech Global Insight.Inc. 40th Anniversary Conference 2
The Economic Background to Business Forecasting A Standard Set of Wave-Makers Systematically Drive Economics Major Oil Price Increases Competing Imports Exchange Rates Additive Forces Restrictive Forces Exports Stock Market Private Sector Spending Federal Reserve & Interest Rates Confidence Shocks GDP = U.S. Output and Income Income Taxes Government Spending Economic models define the magnitudes and timing of market impacts flowing from policy changes or international shocks Modern models begin with projections of 10-15 key domestic policies and global indicators They then translate these into the consequences for prices, volumes, wages, and credit costs in 100+ specific markets Global Insight.Inc. 40th Anniversary Conference 3
Economic Patterns with Staying Power The Responses to Key Factors are Understood Real GDP Growth 8% 6% 4% 2% 0% -2% -4% Actual GDP Jan-76 Predicted GDP (Simple Model) Jan-80 Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 10 Key Forces Controlling GDP Growth Supply potential - Growth in labor force and working age population - Growth in productivity due to technological advances Government budgets - Growth in purchases - Changes in tax rates Financial markets - Federal Reserve rates - Stock and bond market reactions International events and policies - Export growth - Changes in manipulated commodity prices (e.g. oil) - Changes in foreign exchange value of dollar - Extreme consumer confidence shocks from conflict and turmoil Global Insight.Inc. 40th Anniversary Conference 4
Economic Patterns with Staying Power GDP Forecasting Accuracy Blue Chip Consensus Blue Chip consensus GDP forecast is a monthly survey of 50 leading economists. Reported below is the consensus forecast made in November before the indicated year. 8% 7.3% YOY Percent Increase 6% 4% 2% 0% -2% -4% -0.2% 2.5% -2.0% 4.3% 3.8% 3.4% 3.4% 4.2% 3.5% 1.8% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000-0.5% 3.0% 2.7% 4.0% 2.7% 3.6% 4.4% 4.4% 4.2% 5.0% 1.7% Actual Adjusted Forecast Forecast Global Insight.Inc. 40th Anniversary Conference 5
Economic Growth versus a Decade Ago: Remarkable Similarities, Except for the Iraq War Disruption Current Cycle 1991 Cycle Real GDP Year over Year Growth (Quarters) 6% 4% 2% 0% Quarter of Weakest Growth Q3 2001 Quarter of Weakest Growth Q1 1991 History Forecast 6% Blue Chip Forecast Range Top Quintile Consensus Bottom Quintile -2% -2% Current Cycle Sep 1997 Sep 1998 Sep 1999 Sep 2000 Sep 2001 Sep 2002 Sep 2003 Sep 2004 1991 Cycle Mar 1987 Mar 1988 Mar 1989 Mar 1990 Mar 1991 Mar 1992 Mar 1993 Mar 1994 Global Insight.Inc. 40th Anniversary Conference 6
US Employment Was in Position to Rebound Traditionally Until the Iraq War Changed the Outlook 92 1991 Cycle (left axis) 113 1991 Cycle Employment Levels (MM, seasonally adjusted) 90 88 86 84 82 Current Cycle (right axis) 111 109 107 105 103 101 99 Current Cycle Employment Levels (MM, seasonally adjusted) 80 97 Current Cycle 1991 Cycle Sep-98 Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Jan-88 Jul-88 Jan-89 Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Sep-03 Jan-93 Global Insight.Inc. 40th Anniversary Conference 7
Economic Patterns with Staying Power Basic Macro-economic Forces Consumer Attitudes and Reactions The Fed and Investors Indeed, Even High-Tech Global Insight.Inc. 40th Anniversary Conference 8
Consumer Confidence Cycled from Mania to Depression Realistic, Positive Attitudes are Now Prevalent and Sustainable Consumer Sentiment (University of Michigan) 120 110 100 90 80 70 60 Actual Consumer Sentiment Explained by Economic Model Excess Internet-boom Optimism Excess Iraq-War Pessimism Low Inflation & Improving Employment Will Support Buying Plans Normal Impacts of the Economy On Consumer Sentiment Each 1% of Inflation => - 3% 50 Q1 1978 Q1 1979 Q1 1980 Q1 1981 Q1 1982 Q1 1983 Q1 1984 Q1 1985 Q1 1986 Q1 1987 Q1 1988 Q1 1989 Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Each 1% of Unemployment => - 12% per 6 month increase and -4% if sustained Global Insight.Inc. 40th Anniversary Conference 9
Economic Patterns with Staying Power Basic Macro-economic Forces Consumer Attitudes and Reactions The Fed and Investors Indeed, Even High-Tech Global Insight.Inc. 40th Anniversary Conference 10
The Fed Will Raise Rates Significantly in a Year Reacting, with a Lag as Always, to Job Growth and Inflation 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% Employment Growth Consumer Price Inflation Fed Funds Rate History Forecast -2.0% Q1 1988 Q1 1990 Q1 1992 Q1 1994 Q1 1996 Q1 1998 Q1 2000 Q1 2002 Q1 2004 Global Insight.Inc. 40th Anniversary Conference 11
The Fed Has Followed A Consistent Pattern For 40 Years The Motivators: Stable Policy, Inflation, Jobs 20 Federal Funds Rate Regression Model 1960:Q2 through 2003:Q1 Included observations: 172 Factor Affecting Rate Estimated Coefficient t- Statistic constant -0.16-1.1 Prior quarter fed funds rate 0.94 30.6 CPI inflation rate 0.14 4.2 Unemployment rate current quarter -1.97-9.2 prior quarter 1.80 8.6 R-squared 93.7% S.E. of regression 0.8% Fed Funds Rate (Percent) 15 10 5 0 Actual Rate (Blue line) History Forecast Regression estimate (red line) Actual - Estimate -5 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Global Insight.Inc. 40th Anniversary Conference 12
The Bond Market is Equally Consistent The Drivers: The Fed, Deficits, Inflation, Business Cycle 10 - Year Treaury Yield Regression Model 1968:4 2002:4 Driver Coefficient T-Statistic Fed Funds Rate 0.48 17.7 Federal Deficit / GDP Next Year -0.18-3.5 Prior Year -0.08-1.2 Inflation 0.21 3.6 Unemployment Rate 0.36 4.2 Other Minor Factors Long-term share of Federal debt 4.00 3.2 R-squared 92% S.E. of regression 0.68 10 Year Treasury (Percent) 20 15 10 5 0 Actual Rate (Blue line) History Forecast Regression estimate (red line) Actual - Estimate -5 Global Insight.Inc. 40th Anniversary Conference 13
Economic Patterns with Staying Power Bond Yields drive earnings-price ratios Norm : E = i 1.75% P 16% 14% 12% Spread Earnings/Price Ratio 10-Year Bond Rate Averaqe Spread 10% 8% 6% 4% today 2% 0% -2% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Global Insight.Inc. 40th Anniversary Conference 14
As Bond Rates Rise, P-E Ratios Will Decline Yet Remain High: Even a 6% 10-Year Treasury Rate Still Suggests a P-E of 23.5 2001 Bubble in P/E Ratios S&P 500 P/E Ratio 35 33 31 29 27 25 23 21 19 17 15 13 11 9 7 current 2002 2004-5 1998 1999 1997 1994 1990 Red line = norm : 5 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 1984 10-Year Government Bond Yield 1 P E = 1 i 1.75% Global Insight.Inc. 40th Anniversary Conference 15
Economic Patterns with Staying Power Basic Macro-economic Forces Consumer Attitudes and Reactions The Fed and Investors Indeed, Even High-Tech Spending Global Insight.Inc. 40th Anniversary Conference 16
The Strong Links of High-Tech to the Economy Are Long-Standing but Often Overlooked by the Industry Excerpts from a 1994 Discussion with Microsoft Executives and Customers Need-To To-Know Economics For Computer And Software Markets Roger Brinner Executive Director And Chief Economist Data Resources (DRI/McGraw-Hill) Presented To Microsoft Corporation Executive Client Summit Laguna Niguel, California October 28, 1994 Global Insight.Inc. 40th Anniversary Conference 17
Is Your Business Subject To The Business Cycle? One view: - No, sales growth is almost entirely keyed to: Hot product introductions Technology breakthroughs Marketing and sales promotion efforts - In other words, supply issues dominate Global Insight.Inc. 40th Anniversary Conference 18
Is Your Business Subject To The Business Cycle? An Alternate View: - Yes, sales growth is very sensitive to: My customers cash flows My prices relative to those of other solutions open to my customers The prices of hardware or software used in conjunction with my product - In other words, demand issues are vital Global Insight.Inc. 40th Anniversary Conference 19
Is Your Business Subject To The Business Cycle? Computer Hardware Answer: Yes (Percent utilized) (Percent change versus year ago) 95 90 85 80 75 70 1970 1975 1980 1985 1990 70 60 50 40 30 20 10 0-10 -20-30 -40 Capacity utilization (left scale) Compter hardware (right scale) Global Insight.Inc. 40th Anniversary Conference 20
Is Your Business Subject To The Business Cycle? Software links to the economy can be clarified by statistical analysis. Unit sales of software respond as follows: - A 1% rise in corporate cashflow translates into a 2+% rise in sales within 12 months - In addition to this cycle, unit sales growth has averaged 15% per year from 1987-93 - A 1% decline in hardware prices translates into a 1% gain in unit software sales Global Insight.Inc. 40th Anniversary Conference 21
Is Your Business Subject To The Business Cycle? Personal Computer Software Millions of units, seasonally adjusted 25 20 15 10 5 0 1987 1988 1989 1990 1991 1992 1993 Actual Predicted Global Insight.Inc. 40th Anniversary Conference 22
Another Decade of Data Confirms the Patterns 1-3 -5 for Software Growth 1% GDP Growth => 3+ % Cash Flow Growth => 5+ % Software Growth Business Spending on Software (Billions of Dollars) 300 250 200 150 100 50 Actual Software Purchases Purchases Explained by Model ( 87-03) Software Spending Responses Per Percentage Point Change in Key Drivers: 1.7 % software gain per 1% corporate cash flow increase 0.3 % software gain per 1% hardware price decline 2.0 % software gain per 1% software price decline 0 1990 1991 1994 1995 1996 1997 1998 1999 2000 2001 2002 2000 2001 2002 2003 2004 2005 The responses are gradual, taking 2-3 years to fully mature First Quarter Global Insight.Inc. 40th Anniversary Conference 23
Economic Patterns with Staying Power Global Insight.Inc. 40th Anniversary Conference 24