Chapter 12 - Behaviour of the markets Flashcards
The main economic influences on short-term interest rates are government policies.
Outline three such government policies and the link between them and low short-term interest rates.
- Economic growth:
low interest rates => increased consumer and investment spending => economic growth - Inflation:
low interest rates => increased demand for money, which may be met by increased supply of money => higher inflation - Exchange rate:
low interest rates relative to other countries => less investment from international investors => depreciation of domestic currency
List the main theories of the conventional bond yield curve
LIME
Liquidity Preference Theory
Inflation Risk Premium Theory
Market Segmentation Theory
Expectations Theory
Describe Liquidity Preference Theory
Liquidity preference theory – investors prefer liquid assets to illiquid ones.
Therefore, investors require a greater return on long-term, less liquid stocks.
This causes the yield curve to be more upward sloping / less downward sloping than suggested by pure expectations theory.
Describe Inflation Risk Premium Theory
Inflation risk premium theory – the yield curve will tend to be more upward sloping / less downward sloping than suggested by pure expectations theory alone because investors need a higher yield to compensate them for holding longer-dated stocks, which are more vulnerable to inflation.
Describe Market Segmentation Theory
Market segmentation theory – yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
Describe Expectations Theory
Expectations theory – the yield curve is determined by economic factors, which drive the market’s expectations for future short-term interest rates.
List the key economic influences on the equity market
Factors affecting supply: NBP
Number of rights issues
Buy-backs
Privatizations
Factors affecting demand (expected return and risk): RICE
investor’s perception of the RISKINESS of equity market
expectations of real INTEREST rates and inflation
expectations of CURRENCY movements
expectations of real ECONOMIC growth
Explain how expectations of inflation may influence equity prices
Equity markets should be relatively indifferent to high nominal interest rates and high inflation. This is because, if inflation is high, dividend growth would be expected to increase but so would the investor’s required return (or discount rate used to discount the dividends)
Indirect effects of inflation:
1. High inflation is often associated with high interest rates, which can be unfavorable for economic growth, which would reduce equity prices.
- Expectations of high inflation may cause the government to raise real interest rates (to control inflation), which would reduce equity prices.
- High inflation may cause greater uncertainty over inflation. This may encourage investors to increase their demand for real assets such as equities, which would increase equity prices.
In what three inter-related areas do economic influences have an impact on the property market
ODI
- Occupational market - the demand for property for occupation
- Development cycles - the supply of newly completed property developments
- Investment market - supply and demand for properties as investment
List the key economic influences affecting demand in the occupational property market
- Expectations of economic growth, buoyancy of trading conditions and employment levels
- Expectations of real interest rates
- Structural changes (e.g. a move to out-of-town working)
List the key economic influences affecting demand in the investment property market
The investment property market relies to a significant extent on the occupancy market as this provides the rental income and potential for growth
Other factors to consider include:
1. Inflation – rents should increase broadly in line with inflation, although infrequent rent reviews could lead to inflation eroding rental value
- Real interest rates – as these should lead to lower valuation of future rents
- Institutional cashflow, liabilities and investment policy
- Demand from public / private property companies
- The exchange rate, which affects overseas demand
- Returns on alternative investments
- Other economic factors (e.g. tax, political climate)
List the key factors affecting the supply of property
- Development time (gaining consent and construction) – can be up to five years long
- Economic growth – but the peak of the property development cycle lags behind the business cycle, often resulting in a surplus of new property as the economy slows down.
- Real interest rates, which affect the cost of borrowing in order to develop property
- Statutory control – local planning authorities may frequently restrict development
- Fixity of location, high transaction costs and segmented markets
List factors that may affect investors’ preferences
TURF MEN L
A change in the Tax regimes
Uncertainty in the political climate
A change in the Regulations
“Fashion” or sentiment altering
Marketing
Education provided by the suppliers of a particular asset class
No discernible reason
A change in their Liabilities
Main factors affecting bond yield
ROSIE PI
Returns on alternative investments
Other economic conditions that can affect yield ( e.g political news. or ratings downgrade)
Short-term interest rates
Inflation
Exchange rate
Public sector borrowing ( increase supply of bonds, decrease yields)
Institutional cashflow ( More cash, more demand for bonds)
Cost-push inflation
Refers to a situation if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
The average price level can be “pushed” up by an increase in costs.
