Recession

Legislation changes the tax treatment of dividends for all taxpayers, and dividend-paying stocks across every industry fall. This exposure is best classified as:

1. A.Business risk, because the affected companies must now reconsider their payout policies.Wrong. Business risk concerns how well a particular firm runs its operations, not an alteration of the tax code.
2. B.Nonsystematic risk, because only companies that pay dividends were affected by the change.Wrong. The affected group spans every industry, so no amount of spreading across sectors avoids it.
3. C.Credit risk, because the change reduces the cash ultimately available to shareholders.Wrong. Credit risk concerns an issuer's ability to service its debts, which a dividend tax change does not determine.
4. D.Systematic risk, because a change in law reaches the entire market at the same time.Correct. Legislative and political risk is market-wide by nature and cannot be diversified away.

Why: Systematic risk covers the influences that move broad markets: interest rates, inflation, recession, war, and changes in law and regulation. A tax change applying to all dividend-paying shares reaches across industries, so a portfolio spread over many sectors is exposed just the same. Nonsystematic risk is tied to a particular issuer or a narrow group, which is why adding unrelated holdings dilutes it. Had the legislation targeted one industry alone, a broadly spread portfolio would have absorbed only a fraction of the impact.

A financial columnist writes that the economy of Ostmark has "entered a recession." Which observation would most directly support the commonly used working definition of a recession?

1. A.The broad stock market has fallen more than 20% from its most recent high.Incorrect. That is the definition of a bear market. Equity prices are a leading indicator and often decline without a recession following, and they sometimes bottom before a recession ends.
2. B.Consumer prices have risen more than 5% year over year.Incorrect. That describes inflation. Inflation and recession are separate phenomena; when they occur together the condition is called stagflation.
3. C.The central bank has cut its policy rate twice within six months.Incorrect. Rate cuts are a policy RESPONSE to weakness, not a measure of output. A central bank may ease as insurance without any recession occurring.
4. D.Real gross domestic product declined in each of two consecutive calendar quarters.Correct. Two consecutive quarters of falling real GDP is the conventional working definition of a recession, and real GDP is the measure because it removes the effect of price changes.

Why: The conventional working definition of a recession is two consecutive calendar quarters of declining REAL gross domestic product. Real GDP is used because it strips out price changes and measures actual output. Official business-cycle dating bodies look at a broader set of measures, including employment, real income and industrial production, but the two-quarter rule of thumb is the definition tested at this level.

A client wants the portion of her equity portfolio least likely to see demand fall sharply during a contraction. Which industry best fits that description?

1. A.Manufacturing of luxury automobiles and other big-ticket discretionary goodsWrong. Large discretionary purchases are among the first that households postpone when incomes look uncertain.
2. B.Production of household food staples and non-alcoholic beveragesCorrect. People keep eating through downturns, which is why staples producers show comparatively stable demand.
3. C.Commercial construction and the manufacture of heavy machineryWrong. Capital spending on buildings and equipment is highly cyclical and is cut early in a contraction.
4. D.Business travel services and full-service hospitality operationsWrong. Travel budgets are discretionary for firms and households alike and shrink quickly when activity slows.

Why: Industries are classified by how sensitive their revenues are to the business cycle. Defensive industries sell what people buy in every phase, such as food, basic household goods, utilities and many pharmaceuticals, so their earnings hold up through a contraction. Cyclical industries depend on discretionary or capital spending and swing hard with the cycle. Note that defensive does not mean the stock cannot fall, only that demand for the product is comparatively stable.

Two economists debate a recession. One urges higher government spending to lift aggregate demand; the other argues that steady growth in the money supply matters most and that spending programs are largely self-defeating. Their positions are best labeled:

1. A.Keynesian and monetarist, respectively.Correct. Keynesian analysis prescribes fiscal demand management, while monetarism concentrates on the growth of the money supply.
2. B.Monetarist and Keynesian, respectively.Wrong. This reverses the two schools, assigning the spending prescription to the side that distrusts it.
3. C.Monetarist and supply-oriented, respectively.Wrong. The first position is not monetarist, and the second says nothing about incentives to produce.
4. D.Keynesian and mercantilist, respectively.Wrong. The second view concerns money growth, not trade surpluses and the accumulation of foreign reserves.

Why: Keynesian theory holds that output is driven by aggregate demand and that government spending and tax changes can fill the shortfall when private demand is weak. Monetarist theory holds that the quantity of money is the dominant influence on nominal activity and prices, and that discretionary fiscal action is offset or arrives too late. The practical difference between them is which lever each school reaches for, fiscal or monetary. Both accept that policy affects the economy; they disagree over which instrument does the work.