Chapter 12: Behaviour of the markets Flashcards
What is the fundamental factor in any investment decision?
The price of the investment under consideration.
Given a choice an investor won’t buy an investment if they think its price is too high, but they might buy it if they think the price is too low.
At the highest level, asset classes with the greatest risk also have the potential for the greatest return over the long term, however price fluctuations can depress values in the short term.
Government bond markets
Issuing government bonds is the main way governments finance the fiscal deficit.
The demands of purchasers can influence the terms on which debt is issued.
Government bonds in most developed countries are very secure, low risk and so suitable for matching the guaranteed payments arising from selling annuity business.
As issues are large, marketability tends to be good
Fixed-interest bonds will expose investors to inflation risk.
Corporate bond markets
Corporate bonds expose investors to default, inflation, marketability and liquidity risk.
The premiums for accepting these risks are factored into the market price of the bonds, in particular the spread.
So the expected return on corporate bonds will be higher than on a government bond.
The actual returns will however depend upon experience
Marketability and liquidity risks can be mitigated by being a “buy and hold” investor.
Equity markets
Equities expose investors to default, marketability and liquidity risk, as well as the risk of an uncertain dividend stream and resale price.
Equity is a real asset, and so should protect the investor from inflation risk.
Equity markets are heavily influenced by contagion risk, driven by market sentiment.
With the global nature of multinational businesses, some contagion is inevitable, but not to the extent that markets observe.
Guarantees and investment choices
Financial products generally offer guarantees and to ensure customers are not disadvantaged, regulators require providers to hold capital against guarantees.
If product guarantees are covered by guaranteed returns from assets held, the amount of capital earmarked against the product guarantees is reduced.
How is the general level of all markets determined?
By the interaction of buyers and sellers, i.e. supply and demand.
As demand rises, the general level of the market in that asset type rise, and vice versa.
As supply increases, the general level of the market in that asset type decreases, and vice versa.
Demand for most investments is very price elastic because of the existence of close substitutes.
What is the main factor affecting demand?
Investors’ expectations for the level and riskiness of returns on an asset type.
The returns expected by investors reflect a variety of influences, most of them economic.
Investors’ expectations for the level or riskiness of returns on an asset class is therefore another factor that influences demand.
Short-term interest rates are largely controlled by the government through the central bank.
Outline 3 reasons for altering interest rates
- Controlling economic growth: Low real interest rates encourage investment spending by firms and increase the level of consumer spending. Cutting interest rates therefore increases the rate of growth in the short term.
- Controlling inflation: According to the quantity theory, inflation is directly correlated to the amount of money in the economy.
- Controlling the exchange rate: If interest rates in one country are low relative to other countries, international investors will be less inclined to deposit money in that country. This decreases demand for the domestic currency and tends to decrease the exchange rate.
Explain the quantity theory
The quantity theory of money states that there is direct relationship between the quantity of money in an economy and the level of prices of goods and services in that economy.
Therefore, if the amount of money in the economy were to double, then the price levels would also double, causing inflation
Explain the demand-pull inflation
Demand-pull inflation refers to a situation in which there is excess demand within the economy so that firms are able to increase their prices. As a consequence, the general level of prices may be pulled up.
Explain cost-push inflation
Cost-push inflation refers to a situation where if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
Give 3 relationship statuses between the government and the central bank
- The central bank could enjoy complete independence from the government in carrying out monetary policy, including the setting of short-term interest rates.
- Decisions could be the exclusive domain of the government in power.
- The central bank may enjoy a degree of independence when setting short-term interest rates, while remaining subject to certain constraints.
Explain the role of quantitative easing
Quantitative easing is an alternative approach to economic growth if short-term interest rates are already close to zero, and the government has limited scope to reduce interest rates further.
QE works as follows:
- The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market.
- This purchase of assets directly increases the supply of money in the financial system, which encourages banks to lend more and can push interest rates lower.
- The purchase of assets can also reduce the returns on money market assets and bonds, reducing the appeal of those asset types.
Discuss negative interest rates
This is where borrowers are credited with interest, rather than having to pay the lender interest.
It can occur in situations where the central bank has already lowered short-term interest rates to zero to stimulate the economy.
What is a yield curve?
A yield curve is a plot of yield against term to redemption.
Usually the yield plotted is the gross redemption yield on coupon paying bonds but other yields can be used.
List the main theories of the conventional bond yield curve
- Expectations theory
- Liquidity preference theory
- Inflation risk premium theory
- Market segmentation theory
Describe Expectations theory
Expectations theory describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for future short-term interest rates.
If we expect future short-term interest rates to fall, then we would expect gross redemption yields to fall, and the yield curve to slope downwards, and vice versa.
According to this theory, if the yield curve changes shape, this reflects a change in investors’ view of future interest rates.
One of the biggest influences on investors’ expectations of future short-term interest rates is the expected level of future inflation.
If inflation is high, the government is likely to force up short-term interest rates in an attempt to reduce future inflation.
Describe Liquidity preference theory
The liquidity preference theory is based on the generally accepted belief that investors prefer liquid assets to illiquid ones.
Investors require a greater return to encourage them to commit funds for a longer period.
According to liquidity preference theory, the yield curve should have a slop greater than that predicted by the pure expectations theory.
Describe inflation risk premium theory
Inflation risk premium theory suggests that the risk premium should be greater for longer-dated stocks to compensate investors for the fact that long-term estimates of inflation are much less certain than short-term estimates.
Its effect will therefore be similar to that of the liquidity preference premium.
As index-linked bonds are protected against the effect of inflation, inflation risk premium theory does not apply to index-linked bonds.
Describe market segmentation theory
Market segmentation theory says that yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
The concept of market segmentation is based on the following fundamental ideas:
- Different providers and investors have different needs.
- Price is a function of supply and demand, and yields are simply a function of price.
- Suppliers will wish to supply investments of different terms, and so will be more active at different terms in the yield curve.
Describe theories of the real yield curve
The real yield curve is the curve of real yields on index-linked bonds against term to maturity.
The real yield curve is also determined by the forces of supply and demand.
Thus it can be viewed as being determined by investors’ views on future real yields modified according to market segmentation theory and liquidity preference theory.
The government’s funding policy will also influence the shape of the curve.
What are the principal economic factors influencing bond yields?
- Inflation
- Short-term interest rates
- The exchange rate
- Public sector borrowing - the fiscal deficit
- Institutional cashflow
- Returns on alternative investments
- Other economic factors
Explain the influence of inflation on bond yields
Inflation erodes the real value of income and capital payments on fixed coupon bonds.
Expectations of a higher rate of inflation are likely to lead to higher bond yields and vice versa.
Explain the influence of short-term interest rates on bond yields
The yields on short-term bonds are closely related to returns on money market instruments, so a reduction in short-term interest rates will almost certainly boost prices of short bonds.
However, the effect of this on long-bonds can be debated.
If the market also revised downwards its estimate of future short-term interest rates at all terms, then long-term bond yields would fall.
However, if the investors of long-bonds see it a a sign of monetary easing, with potential inflationary consequences, the yield on long bonds might decline by a smaller amount, or even rise.
Explain the influence of the exchange rate on bond yields
A significant part of the demand for government bonds in many markets come from overseas.
Changes in the expectations of future movements in the exchange rate will affect the demand from overseas investors.
It will also alter the relative attractiveness of domestic and overseas bonds for local investors.
Investment return from overseas investment have 2 components:
1. the return achieved by the investment as measure in the local currency
2. the profit or loss from exchange rate movements
In the short term, interest rates are a key determinant of the exchange rate.
In the long run, the exchange rate will tend to follow its purchasing power parity path reflecting the market’s view of relative levels of US and UK inflation.
Explain the influence of the fiscal deficit on bond yields
If the government’s fiscal deficit is funded by borrowing, the greater supply of bonds is likely to put upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding.
Selling Treasury bills would increase short-term interest rates, while printing money will lower rates but increase expectations of inflation.
Either way, bond yields would tend to rise, thus an increase in the fiscal deficit will tend to cause bond yields to rise.
Explain the impact of the fiscal deficit upon the funding policy adopted by the government
- If the current government is committed to a full funding policy, this means meeting the whole of the deficit through borrowing, rather than printing money
- the form the government borrowing takes e.g. conventional or index-linked bonds, Treasury bills and / or other forms, such as borrowing from individual investors.
Explain the influence of institutional cashflow on bond yields
If institutions have an inflow of funds because of increased levels of savings they are likely to increase their demand for bonds
Changes in regulations and investment philosophy can also affect institutional demand for bonds.
Explain the influence of alternative investments on bond yields
The relative attractiveness of alternative investments, both at home and overseas, will influence the demand for bonds, and hence the yields that they offer.
The yields on US government bonds are particularly important due to their vast quantities.
Explain the influence of other economic factors on bond yields
Almost any piece of economic news that has implications for inflation and short-term interest rates will influence the level and shape of the yield curve.
The impact of other economic factors can therefore usually be understood in terms of these two quantities.
Compare government bond yields to corporate bond yields.
Economic factors which adversely affect prospects for corporate profitability are likely to increase the perceived risk of corporate bonds relative to government bonds.
This will increase the general level of the yield margin of corporate over government debt.
The availability and price of government debt might affect the actions of otherwise risk-averse investors.
Supply side issues also have an impact. If equity market conditions are depressed, companies may find it easier to raise funds through issues of corporate debt than through equity issues. oversupply of corporate debt reduces prices and increases yields
Explain the yield margin
The yield margin of corporate over government bonds primarily reflects the differences in marketability and default risk.
Investors’ perceptions of default risk may increase in times of recession, so the size of the yield margin is expected to increase as the economy moves into recession.
What is the main factor influencing the level of the equity market
Expectations of profits:
Investors’ expectations of future corporate profitability and the value of these profits largely determine the general level of the equity market.
Give other factors that influence the general level of equity markets
- Expectations of real interest rates and inflation
- Investors’ perceptions of the riskiness of equity investment
- The real level of economic growth in the economy
- Expectations of currency movements
- Factors affecting supply:
- the number of rights issues
- share buy-backs
- privatisations - Factors affecting demand:
- changes in tax rules
- institutional flow of funds
- the attractiveness of alternative investments
Discuss the impact of real interest rates on expectations of profit
Real interest rates have two important effects:
- Low real interest rates should help to stimulate economic activity, increase the level of corporate profitability, and hence raise the general level of the equity market.
- Also the rate of return required by investors should be lower, so the present value of the future dividends will be higher
Discuss the impact of inflation on the expectations of profit
Equity markets should be reasonably indifferent towards high nominal interest rates and high inflation.
if the rate of inflation is high, the rate of dividend growth would be expected to increase in line with the return demanded by investors.
There are some indirect effects from inflation:
- It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices
- Real interest rates are probably more important than nominal interest rates for investors. Investors expecting high inflation may also expect the government to increase real interest rates in response.
- Often a risk in inflation makes the prospects of inflation less certain. Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Nervousness in the bond market might result in an increase in equity investment, as equities should provide a hedge against inflation. This would tend to increase the relative level of the equity market at the expense of the bond market
Discuss the impact of Equity risk premium on the expectations of profit
The equity risk premium is the additional return that investors require from equity investments to compensate for the risks relative to risk-free rates of return.
The equity risk premium fluctuates from time to time, depending on the overall level of confidence of investors and their views on risk.
Discuss the impact of real economic growth on the expectations of profit
In general, real dividends, and therefore the fundamental value of companies, would be expected to grow roughly in line with real economic growth.
Therefore, changes in investors’ views on economic growth have a major effect on the level of the equity market.
Discuss the impact of currency on the expectations of profit
A weaker domestic currency makes exports more competitive, so profits of companies that export goods and services, should increase.
A weaker domestic currency makes imports more expensive, which reduces corporate profits if firms cannot pass the higher costs of imported raw materials to consumers.
What are the three main interrelated areas in which economic influences have an impact on the property market?
- Occupation
- Development cycles
- The investment market
The interaction between occupational demand and the supply of property for rent determines the market level of rents.
The capital value of rented property is determined by the investment market.
Discuss the economic influences on commercial property and occupation
Economic growth:
Tenant demand is closely linked to the buoyancy of trading conditions and GDP.
Other things being equal, economic growth increases demand for commercial and industrial premises.
However, the impact of economic growth will not necessarily be uniform across the different property sectors or throughout all regions of a country.
Any factor that affects economic activity, such as real interest rates, will affect occupational demand for property.
Structural changes in the demand for property:
New patterns of economic activity, domestically and globally, change demand patterns.
For example, increases in the number of people working from home and shopping online would decrease demand for property.
Discuss the economic influences on commercial property and development cycles
Markets can be viewed in terms of the existing stock plus forecast additions to stock, but there are supply-side lags and these can be difficult to forecast.
The development pipeline can be long, which can result in surpluses of available property when the economic cycle is in a downturn, and shortages as the economy improves.
This makes property values more volatile, as the supply of property cannot keep up with the changes in demand.
Discuss the economic influences on commercial property and the investment market
The property investment market relies on the occupancy market as this provides the investment income and the potential for rental growth.
Inflation:
Property investment returns have been a good hedge in the long run against unexpected inflation.
If there are no other external influences, freeholders can increase rents with inflation so that the real value of the rent is not maintained.
Real interest rates:
Higher real interest rates should lead to a lower valuation of future rents and therefore lower capital values.
The relationship between interest rates and property rental yields is unclear in the short term.
In the longer term, high long-term bond yields tend to push up property investment yields.
Other factors:
The sources of investment funds and whether cashflows are positive or negative, are important in determining the state of the property investment market.
The main sources are:
- institutional investors
- public / private property companies using bank debt
- international investors
Where overseas investors are significant purchasers of property, the exchange rate will influence demand levels.
Discuss the economic influences on residential property
Additional economic considerations apply to residential property market in territories such as the UK where owners occupy their own property, usually purchased with the aid of a mortgage.
These considerations do not apply where major landlords rent out many residential properties.
Residential property values are entirely driven by supply and demand.
Under which circumstances will the demand for an asset change?
- Investors’ opinions of the characteristics of the asset remain unchanged but external factors alter the demand for that asset. These factors include:
- investors’ cashflows
- investors’ preferences
- the price of other investment assets - Investors’ perceptions of the characteristics of the asset, principally risk and expected return, alter
Discuss the effect of investors’ cashflows on demand
The amount of money available for investment by institutional investors can have a significant impact on market prices
This is especially true of changes in the flow of funds into institutions with tightly specified investment objectives.
Discuss the effect of Investors’ preferences on demand
Investors’ preferences for a particular asset class can be altered by:
- a change in their liabilities
- a change in the regulatory or tax regimes
- uncertainty in the political climate
- ‘fashion’ or sentiment altering
- marketing
- investor education undertaken by the suppliers of an asset class
- sometimes for no discernible reason
Discuss the effects of the price of alternative investments on demand
All investment assets are, to a greater or lesser extent, substitute goods.
This is particularly so if we consider investment at the individual security level, but it is also true across asset classes or across international markets.
There is therefore a strong correlation between the prices of different asset classes.
Discuss the effects of the equity markets on supply
An increase in supply will cause downward pressure on share prices
The supply of shares increase as a result of:
- rights issues
- privatisations of previously nationalised companies
- new share issues by companies moving to a shareholder structure
A spate of rights issues is most likely when:
- company directors think that the stock market is unusually buoyant
- company balance sheets are too weak to support the scale of operations desired by the directors
Additionally, it might be expected that during a recession there will be more rights issues aiming to raise additional finance for companies that are in financial difficulty.
Discuss the effects of the bond markets on supply
In government bond markets, the supply is largely controlled by:
- the government’s fiscal deficit
- its strategy for financing the deficit
- the redemption of existing government bonds
Discuss the effects of other investment markets on supply
Occasionally, supply is increased by technological innovation. It can be argued that this is the case in the derivatives markets where a greater understanding of the pricing of and reserving for complex products has allowed investment banks to supply them to end users more cheaply, thus increasing the quantity demanded.
