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J10 - Discretionary Investment Management > 8. Economic Environment > Flashcards

8. Economic Environment Flashcards

1
Q

A. The economy (page 2)

A

An economy comprises two distinct groups or economic agents:

  1. Consumers (individuals)
  2. Firms
  • Individuals supply firms with the productive resources of the economy (land, labour and capital)
  • in return for an income
  • In return these same individuals use this income to buy the entire output produced by the firms using these resources
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2
Q

A. The economy (page 2)

CONTINUED

A

Econonic activity can be measured in one of three ways:

  1. Total income paid by firms to individuals
  2. Individual’s total expenditure on firm’s output
  3. By the value of total output generated by firms

Each of the measures above should produce the same answer in a simplified model.

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3
Q

A. The economy (page 2)

CONTINUED

A

However, as economies develop the model becomes more complex. Complexities arise from:

  • Individuals saving some of their income
  • Financial markets channelling these savings to firms for future production
  • Government spending and taxation decisions
  • International trade becoming part of the system

Consequently, the circular flow becomes subject to:

  • interjections in the form of business investment, government spending and firm’s exports to overseas economies
  • leakages in the form of savings, taxation and imported goods and services
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4
Q

A1. Gross domestic product (page 3)

A

The most closely watched indicator of economic activity is GDP.

GDP estimates the total value of income/production from economic activity.

To explain GDP it is necessary to define Market Value (MV) and Final Output (FO):

MV: is the value of the Final Output at current prices inclusive of indirect taxes such as VAT

FO: defined as the product or service that is purchased by the end user

GDP measures the total MV of all domestically produced final goods and services during a calender year.

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5
Q

A1. Gross domestic product (page 3)

CONTINUED

A

GDP Calculation:

GDP = C + I + G + (X - M)

C = Consumption (expenditure of households on goods and services)
I = Investment (expenditure of businesses and individuals for capital investment)
G = Government spending
X = Exports
M = Imports
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6
Q

A2. Gross national product (page 4)

A

GNP is GDP plus contributions made by individuals and firms who are nationals but based overseas.

This contribution is known as net property:
- comprises wages, profits, interest and dividends

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7
Q

B. Economic and business cycles (page 4)

A

BoE thinks that economic cycles are shortening and are only 6 years in length.

Cycles measured between successive peaks or successive troughs.

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8
Q

B1. Economic cycles (pages 4 & 5)

A

Typically split into four main phases:

  1. Recovery (followed by expansion) UP
  2. Boom UP then DOWN
  3. Slowdown or contraction DOWN
  4. Recession DOWN then UP
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9
Q

B1. Economic cycles (pages 4 & 5)

CONTINUED

A

Expansion:

  • business experience high sales and profits
  • prices rise due to customer demand
  • inflation rises
  • interest rates are increased to encourage saving and discourage spending

Boom:
- occurs when the economy is growing at its fastest

Slowdown:

  • the economy begins to slow as a result of the increase in inflation rates
  • inflation is still high so interest rates stay high too
  • sales drop as consumers become more cautious
  • unemployment rises and businesses collapse

Recession:

  • a severe slowdown will result in recession
  • output growth sluggish
  • company profits are weak
  • inflation and interest rates are now falling
  • TROUGH is the bottom of a recesion

Recovery:

  • more spending as consumer confidence grows
  • inflation and interest rates remain low
  • output growth strengthens
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10
Q

B2. Trends in economic activity (pages 5 & 6)

A

The rate or trend of sustainable growth depends on:

  1. growth and productivity of the work force
  2. rate at which domestic savings and capital are challened into new and innovative technology
  3. extent of development of infrastructure to support transport, communication and energy needs

Economy grows in excess of its trend growth rate: actual output exceeds potential output, often with inflationary consequences

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11
Q

B2. Trends in economic activity (pages 5 & 6)

CONTINUED

A

Movements in GDP:

  1. Economy CONTRACTING: GDP falls compared to previous quarter
  2. Economy in RECESSION: two successive quarters of the GDP falling
  3. Economy EXPANDING: GDP rises compared to the previous quarter
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12
Q

B2. Trends in economic activity (pages 5 & 6)

CONTINUED

A

Public Sector Net Borrowing Requirement:

  • this is the difference between the Government’s expenditure and revenues (taxation)

UK Government typically has a Borrowing Requirement - i.e. it spends more than it takes (there is a deficit between expenditure and receipts)

RECESSION: PSNCR deficit likely to grow (weak taxation)
EXPANDING: PSNCR deficit reducing (increasing taxation)

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13
Q

B3. Economic cycles and investments (page 6)

A

Fluctuations in the rate of economic growth create pronounced cycles in the prices of fixed-interest securities and equities.

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14
Q

B3A. Fixed-interest securities (page 6)

A

BOOM:

  • higher spending
  • higher inflation
  • higher interest rates
  • BOND YIELDS INCREASING to compete
  • BOND PRICES FALLING

FALLING INFLATION AND INTEREST RATES:

  • BOND PRICES INCREASE
  • Fixed-interest becomes more attractive pushing up bond prices
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15
Q

B3B. Equities (pages 6 & 7)

A

EXPANSION:
- prices increase as companies strengthen

BOOM:
- prices falter as interest rates increase

CONTRACTION:
- price fall due to a decline in company earnings

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16
Q

B4. Key economic indicators (pages 7 & 8)

A
  • Earnings Growth (increase in average employment earnings)
  • GDP
  • GNP
  • CPI
  • Producer Prices Index (PPI) - prices of good brought and sold in the UK
  • Purchasing Managers Index (PMI) - health of the manufacturing sector
  • Unemployment Rate (number of men and women unemployed)
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17
Q

C. Balance of payments and international trade (page 8)

A

BALANCE OF PAYMENTS:

  • a record of a country’s trade transactions with the rest of the world
  • measured in terms of RECEIPTS and PAYMENTS

RECEIPT:

  • represents sterling flowing into the country
  • or a transaction that requires the exchange of foreign currency for sterling

PAYMENT:
- opposite of a receipt

A country with a surplus is accumulating money within the economy.

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18
Q

C. Balance of payments and international trade (page 8)

CONTINUED

A

The balance of payments consists of two offsetting components:

  1. CURRENT ACCOUNT
    - deals with imports and exports of goods and services
  2. CAPITAL & FINANCIAL ACCOUNT
    - deals with foreign investments in the UK and UK investments abroad
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19
Q

C1. Current account (pages 8 & 9)

A

Consists of transactions in good (visible trade) and services (invisiable trade):

VISIBLE TRADE: imports and exports of good such as transport equipment, oil, raw materials etc

INVISIBLE TRADE: imports and exports of services such as tourism and financial services

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20
Q

C1. Current account (pages 8 & 9)

CONTINUED

A

Current account divided into four parts:

TRADE IN GOODS: exports and imports of products
TRADE IN SERVICES: export/import of services
PRIMARY INCOME: UK resident-earned salaries
SECONDARY INCOME: overseas aid

DEFICIT on the current account:
- more goods and services have been imported into the UK than sold abroad

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21
Q

C2. Capital and financial account (page 9)

A

Records all movement of money into and out of the country for investment.

  • sales of assets earn foreign currencies
  • purchases of assets use up foreign currencies
  • UK would have a surplus if foreign investors invested more than UK investors invested overseas

Any current account deficit must be made up by the capital account.

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22
Q

C2. Capital and financial account (page 9)

CONTINUED

A

If there is a net deficit on both the current and capital accounts, the Official Reserves of foreign currencies owned by the BoE have to be used to finance it:

OFFICIAL RESERVES are made up of:

  • foreign currencies
  • gold
  • IMF special drawing rights
  • UK’s reserve tranche position at the IMF
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23
Q

C3. Importance of the balance of payments (pages 9 & 10)

A

If a current account is in deficit, the capital account must be in surplus:

  • A deficit inflow of income must be offset by a surplus inflow of capital
  • a country running a current account deficit must be a net importer of capital

The opposite applies where the capital account is in deficit:
- the country must be a net exporter of capital

A large current account deficit must be financed by overseas lenders.

A currency crisis may occur if the lenders lose confidence in the country’s currency and its economy.

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24
Q

C4. Exchange rates (pages 10, 11 and 12)

A

UK exports create a demand for sterling by foreign buyers and the satisfaction of this demand increases the supply of foreign currencies in the foreign exchange markets.

UK imports create a domestic demand for foreign currencies with which to pay for the imports and meeting this demand decreases the supplies of foreign currencies in the foreign exchange markets.

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25
Q

C4. Exchange rates (pages 10, 11 and 12)

CONTINUED

A

Real exchange rate: the effective exchange rate between two countries adjusted to incorporate the differences in their rates of inflation.

Is a good indicator of a country’s competitiveness:

  • if the real exchange rate rises, domestic goods become more expensive relative to foreign goods
  • if the real exchange rate falls, domestic goods become cheaper relative to foreign goods and demand for them increases
26
Q

C4. Exchange rates (pages 10, 11 and 12)

CONTINUED

A

Strong Currency Benefits:
- reduces the cost of imported goods

Weak Curency Problems:
- increases the cost of imported goods

Strong Currency Problems:

  • exports become too expensive
  • weakens the country’s competitive position
27
Q

C4. Exchange rates (pages 10, 11 and 12)

CONTINUED

A

Effects of a rise in exchange rates:

  • exports become expensive, so less goods demanded
  • imports become cheaper, so demand increases
  • aggregate demand falls, leading to lower growth
  • inflation falls

Effects of a rise in exchange rates are the oppostie.

28
Q

D. Fiscal and monetary policy (pages 12 & 13)

D1. Fiscal policy (pages 12 & 13)

A

FISCAL POLICY: describes the short-term effect on the economy of altering the levels of government spending and taxation.

Governments spell out how their spending and taxation will influence:

  • levels of demand in the economy
  • levels of economic activity

RECESSION:

  • government may increase its spending
  • or cut taxation to boost the economy

BOOM:

  • government may reduce spending
  • or increase taxation to dampen demand

AN INCREASE IN GOVERNMENT SPENDING has more impact on the economy than a decrease of income tax of the same amount.
- this is because the bulk of such expenditure will be spent on domestically produced goods and services

29
Q

D1. Fiscal policy (pages 12 & 13)

CONTINUED

A

Fiscal Policy may affect the behaviour of individuals and companies as follows:

INDIVIDUALS
- different tax treatment of various types of assets will affect investment decisions

COMPANIES

  • the tax treatment of a company’s earnings will affect its dividend policy
  • and the choice of raising capital through equities or debt
30
Q

D1. Fiscal policy (pages 12 & 13)

CONTINUED

A

Problems caused by a budget deficit:

  • to reduce them, taxes need to be raised, or cuts in public spending
  • sustained deficits lead to rising interest rates
  • sustained deficits cause a rise in public debt
31
Q

D2. Monetary policy (pages 13, 14 , 15 & 16)

A

MONETARY POLICY: attempts to stabilise the economy by controlling interest rates and the supply of money.

In the short term: changing interest rates has the greatest affect.

MONEY SUPPLY: the amount of money available in the economy to purchase goods and services.

32
Q

D2. Monetary policy (pages 13, 14 , 15 & 16)

CONTINUED

M0 and M4

A

M0:

  • comprises notes and coins in circulation plus banks’ operational deposits with the BoE
  • known as ‘NARROW MONEY’
  • an indicator of consumer spending
  • growth in M0 means that spending is buoyant
  • contraction in M0 means more cautious spending
  • reflects changes in the economic cycle

M4:

  • comprise notes and coins in circulation plus all instant access and time deposits
  • known as ‘BROAD MONEY’
  • an increase in a demand for loans will be reflected in a higher M4
33
Q

D2. Monetary policy (pages 13, 14 , 15 & 16)

CONTINUED

BoE and the MPC

A

BoE’s two core purposes:

  1. Maintaining financial stability
  2. Maintaining monetary stability (stable prices, i.e. low inflation and confidence in the currency)

Monetary Policy Committee (MPC):

  • nine members (5 BoE and 4 external)
  • meet eight times a year
  • control inflation through interest rate policy
  • inflation targe is 2% (based on CPI)
34
Q

D2. Monetary policy (pages 13, 14 , 15 & 16)

CONTINUED

REPO MARKET

A

Repo: sale and repurchase agreement using gilts

BoE uses its repo operations to influence short-term interest rates as follows:

  • can lend money in exchange for gilts so injects money into the financial system
  • can borrow money in exchange for gilts thereby reducing money supply

Reducing short-term interest rates eases monetary policy:

  • longer-term interest rates should reduce
  • leads to rising asset prices
  • encourages borrowing and therefore spending
  • stimulates the market

Increasing short-term interest rates tightens monetary policy:

  • increase in longer-term interest rates
  • lower asset prices
  • less willingness to borrow

Takes between 18 months and two years for a change in interest-rates to kick in.

35
Q

D2. Monetary policy (pages 13, 14 , 15 & 16)

CONTINUED

QUANTITATIVE EASING

A

QE involved the central bank creating money:

  • it buys assets such as government bonds and private equity debt
  • the sellers then have more money to spend whilst the central bank holds the assets as part of its reserves
36
Q

E. Inflation (pages 17 & 18)

A

Inflation is typically categorised as one of the following:

COST-PUSH INFLATION

  • increased business costs are passed onto the consumer
  • consumers then demand higher wages causing a spiral

DEMAND-PULL INFLATION
- economy is operating beyond its full employment level of output

37
Q

E. Inflation (pages 17 & 18)

CONTINUED

A

DISINFLATION

  • decrease in the rate of inflation
  • price rise but at a slower rate

DEFLATION

  • where prices decline over time
  • opposite to inflation
  • consumers become reluctant to buy expensive items, knowing that they will become cheaper in the future
  • as prices fall, so does output. This results in unemployment as products are not needed as much

STAGFLATION
- combination of stagnant growth and inflation

EFFECTS OF INFLATION ON INVESTMENTS

  • CASH: interest rates need to be higher than inflation in order to give a positive rate of return
  • BONDS: inflation will erode the purchasing power of the investment received if the interest rate is less than inflation (if fixed-interest). If index-linked, should keep pace with inflation
  • EQUITIES: usually seen as a good hedge against inflation
38
Q

F. The financial system (page 18)

A

Financial systems provide four essential functions in a modern economy:

  1. Provide a conduit into which savings are channelled into capital investment
  2. Provide a means by which savers’ desire for liquidity can be matched by borrowers’ requirement for committed long-term funds
  3. Allow people and companies to ensure against risks they do not wish to take, but that others are prepared to assume in return for a payment
  4. Allow investors to diversify risks across a number of different investment products
39
Q

F1. Savings and banking system (pages 18 & 19)

A

Banks transform savings deposits into longer-term loans that borrowers require (mortgages).

‘Maturity Transformation’ - where the term on the loans becomes longer than the maturity of the deposits.

Can cause a ‘run on a bank’ where depositors rush to withdraw savings but the bank cannot meet the demand. I.E. NORTHERN ROCK.

40
Q

F2. Other functions of the financial system (page 19)

A
  1. Insurance
  2. Mortgages
  3. Long-term savings
41
Q

F3. Financial markets (pages 19 & 20)

A

Financial markets are an important alternative to banks as a channel between savers and borrowers.

Some companies can raise funds more easily and with better terms on the financial markets than if they were to borrow from banks.

DISINTERMEDIATION - bypassing the banks

SECURITISATION - packaging debt into securities

42
Q

F4. The 2008-09 financial crisis (pages 20 & 21)

A

The US sub-prime crisis would on its own have caused worldwide losses as many European banks and insurers had bought enough ‘toxic’ assets.

The crisis extended to a global problem because the US Government refused to bail-out Lehman Brothers in September 2008.

Other banks worldwide cut back their exposure to other banks perceived as weak, and this was because Lehman Brothers acted as a counterparty to a huge number of derivatives trades and ultimately failed.

43
Q

G. Economics and industry (page 21)

G1. Demand (page 21)

A

DEMAND: the amount of a product or service that a consumer is willing and able to buy at a given price.

Factors that affect the level of demand:

  • price
  • buyer’s income
  • demand for alternatives
  • demand for other goods or services
  • ease of purchasing
  • whether the buyers like the product

There is an inverse relationship between the price and quantity of a product.

44
Q

G2. Supply (page 22)

A

SUPPLY: the amount of a product that a producer is willing to sell.

Factors that affect supply:

  • price
  • manufacture and distibution costs
  • supply of alternate products
  • supply of products produced at the same time
  • unexpected events that make supply more difficult or make it easier
45
Q

G3. Short- and long-run equilibrium (page 22)

A

Equilibrium is the state of balance between supply and demand for a product.

Short term: producers and consumers may not have time to adjust their buying and selling behaviour
Long term: they should have time to adjust

Equilbrium is where low prices mean high demand and lack of supply, so producers increase prices until a state of equilibrium is reached.

46
Q

G4. Supply and demand for productive resources (page 22)

A

Two main types of resource used in the production and supply of goods and services:

  1. Human resources (skill and knowledge of workers)
  2. Non-human resources (tools and machines)

Demand for a resource is ‘derived demand’:
- where the demand for the resource is derived from the demand of the product that it is being used to produce

47
Q

G5. The cost of capital (page 23)

A

Factors that affect supply and demand, and therefore the cost of money are:

  1. PRODUCTION OPPORTUNITIES
  2. TIME PREFERENCES FOR CONSUMPTION
  3. RISK
  4. INFLATION
48
Q

G6. Demand and supply in the labour market (pages 23 & 24)

A

The economic cycle has a major impact on the levels of demand for labour and therefore unemployment.

During the four major stages of the economic cycle the effects are:

  1. RECESSION: unemployment at its peak
  2. EXPANSION: unemployment falls
  3. BOOM: unemployment at its lowest
  4. SLOWDOWN: unemployment is rising
49
Q

G6. Demand and supply in the labour market (pages 23 & 24)

CONTINUED

A

Types of unemployment:

  1. FRICTIONAL: qualified jobseekers become temporarily unmatched with job openings
  2. STRUCTURAL: caused by structural changes to the economy, such as a decline in a particular industry
  3. CYCLICAL: caused by changes in the overall level of economic activity

An economy at full employment only suffers from Frictional and Structural unemployment. The rate of unemployment in this circumstance is known as the ‘natural rate of unemployment’.

50
Q

G6. Demand and supply in the labour market (pages 23 & 24)

CONTINUED

A

Consequences of unemployment diverging from the natural rate are:

  • Economy has output levels above the level of full unemployment: inflationary pressures likely to emerge (wages increase)
  • Output levels below full employment: disinflationary measures are likely to appear (wages decrease)
51
Q

G7. Competition and monopolies (pages 24 & 25)

A

There are very few ‘perfectly competetive economies’ (agriculture being one).

Instead of perfect competition, most markets have one or more of the following:

  • barriers for entry for new producers
  • differentiated products
  • firms with a dominant market position
  • lack of perfect consumer knowledge

Competition has a number of advantages for the economy:

  • producers have to operate efficiently and meet their customer’s needs
  • producers have an incentive to innovate and find lower cost methods of manufacture and supply
  • consumers receive better value through lower prices
52
Q

G7. Competition and monopolies (pages 24 & 25)

CONTINUED

A

In contrast to competition, monopolies arise because of barriers.

Main characteristics of a monopoly are:

  • single producer
  • no substitutes for the product or service
  • high entry barriers

Main types of barrier are:

  • High set-up costs
  • Economies of scale
  • Government regulations
  • Patents
  • Control over an essential resource
  • High entry barriers
53
Q

H. Trends in investment markets (page 25)

H1. Role of government (pages 25 & 26)

A

Governments now push for more regulation of banks due in part to having substantial assets held with them that they need to return to strength following the financial crisis.

Stress tests are now forced upon financial institutions by the UK regulator.

54
Q

H2. Impact of policies (page 26)

A

Government policies can affect:

  • interest rates and currencies
  • elections and economic cycles

With interest rates at near-zero, Government policies are needed to affect the economy more than ever.

55
Q

H2A. Interest rates and currencies (pages 26 & 27)

A

Both are affected by political developments such as the financial crisis (where QE had to be used to stop inflation falling below 2%) and Brexit where the US/Sterling exchange rate fell.

56
Q

H2B. Elections and economic cycles (page 27)

A

Economies reigned in just after an election, with a boom occuring just before the next.

57
Q

H3. Brexit (pages 27 & 28)

A

UK regulators have put in place measures that provide equivalence to many of the existing EU rules following the Brexit transition period.

58
Q

H4. Impact of international events (pages 28 & 29)

A

Direct investment in multinational companies in overseas markets has been a powerful driver of globalisation. The effects of globalisation are as follows:

  • investors can take advantage by investing in foreign markets or in multinational companies with large overseas operations
  • it puts at a disadvantage low-skilled, labour-intensive industries in the developed world that compete with developed markets
  • it is felt in the non-manufacturing sector of the economy with many financial services companies having outsourced their call centres to foreign countries such as India

When investing, the political (and therefore the economic) stability and viability of a country needs to be considered, as political and/or government actions or events could have an adverse effect on investment markets. Such actions or events could be:

  • significant changes in taxation or spending policies
  • war or major military conflicts
  • terrorist attacks
  • leadership of governments changing
59
Q

H5. Speculative fashions (page 29)

A

BUBBLES: Occur when investors lose sight of fundamnetal values and buy assets because they think prices will continue to rise (buy en mass)
- known as GREATER FOOL THEORY
CRASHES: Occur when investors think prices will fall so sell their shares en mass

60
Q

H6. Socio-economic issues (pages 29 & 30)

A

Ageing population due to:

  • people living longer
  • declining birth rates

Increased longevity will lead to higher savings as people prepare for longer retirements. This has the following consequences:

  • as people become richer demand for services grows
  • demand for manufactured goods declines

This is also a reason why inflation needs to be combated, because those savers want their money in retirement to keep its purchasing power.

61
Q

H7. Technological change (pages 30 & 31)

A

A country’s capacity for technological change is usually measured by the proportion of national output devoted to research and development.

62
Q

Chapter 8 Key Points (pages 32 & 33)

A

THE ECONOMY:
- the most common method of calculating GDP is the expenditure method:

GDP = C + I + G + (X - M)

C = Consumption (expenditure of households on goods and services)
I = Investment (expenditure of businesses and individuals for capital investment)
G = Government spending
X = Exports
M = Imports

ECONOMIC & BUSINESS CYCLES:

  • Four main phases of the economic cycle:
    1. Recovery/expansion
    2. Boom
    3. Slowdown/contraction
    4. Recession

Difference between the government’s expenditure and revenues in the ‘public sector net borrowing requirement’

BALANCE OF PAYMENTS & INTERNATIONAL TRADE:

  • deficit on the current account means that more goods and services have been imported into the UK than have been sold abroad
  • a large current account deficit must be financed by overseas lenders

FISCAL & MONETARY POLICY:

  • Fiscal policy is the use of government spending and taxation to influence both the levels of demand in the economy and the level of economic activity
  • Monetary policy attempts to stabilise the economy by controlling interest rates and the supply of money
  • Fiscal/monetary policies used to smooth the economic cycles

INFLATION:

  • is the rate of change in the general price level or the erosion in the purchasing power of money
  • is a major consideration for investors

THE FINANCIAL SYSTEM:

  • financial systems provide a conduit through which savings are channeled into capital investment
  • people can insure against risk and diversify to manage risk

ECONOMICS & INDUSTRY:

  • equilibrium is the state of balance between supply and demand for a product
  • may not have time to adjust behavior in the short term but may in the long term

TRENDS IN INVESTMENT MARKETS:

  • governments can influence economic and financial conditions such as interest rates, currency alignments, inflation and economic cycles, which can impact investment markets
  • people are living longer, leading to more retirees and higher wealth holdings
  • technological change is a key determinant of higher productivity and has had an impact on all aspects of an organisation’s work, with firms that have successfully incorporated technology gaining a competitive edge over their rivals

J10 - Discretionary Investment Management (15 decks)

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