Chapter 20: Economic influences on investment markets

Question 1

Short-term interest rates are determined largely by government policy, as the government balances… (3)

Answer 1

• the need to control inflation
• the need to encourage economic growth
• management of the level of the exchange rate.

Question 2

6 Main factors affecting bond yield

Answer 2

• inflation
• short-term interest rates
• institutional cashflow
• fiscal deficit
• exchange rate
• returns on alternative investments, both domestic and overseas

Question 3

Level of the equity market is determined by ….

Answer 3

investors’ expectations of future corporate profitability and the value of those profits.

Question 4

Main influences on the level of equity (4)

Answer 4

• expectations of real interest rates & inflation
• investors’ perceptions of the riskiness of equity investment
• the real level of economic growth in the economy
• expectations of currency movements

Question 5

Other factors influencing the level of equity in the market (6)

Answer 5

• POLITICAL climate
• ALTERNATIVE investments
• TAXATION
• institutional cashflow
• OVERSEAS equity markets
• SUPPLY factors

Question 6

Property market:

Economic factors can affect: (3)

Answer 6

• occupation market
• development cycles
• investment market

Question 7

Key economic factors on the property market

Answer 7

• economic growth
• real interest rates
• inflation
• institutional cashflow
• exchange rates

Question 8

Inelastic supply of property is caused by: (5)

Answer 8

• time required to develop new properties
• planning permission rules and the limited physical space in some areas
• fixity of location
• high transaction costs
• segmented markets

Question 9

7 Economic factors influencing bond yields

Answer 9

• FISCAL DEFICIT (issue bonds & print money)
• OVERSEAS demand
• RISK (liquidity & inflation risk premium)
• EXPECTED RETURN (Inflation & Interest rate
• returns on alternative investments
• REDEMPTIONS
• MARKET SEGMENTATION (Institutional Cashflows; Investor preferences)

Question 10

Inflation effects on bond yield

Answer 10

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.

Question 11

Short-term interest rate effects on bond yields

Answer 11

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.

Investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. so the yield on long bonds might decline by a smaller amount, or even rise.

Question 12

Fiscal deficit effects on bond yields

Answer 12

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.

Question 13

Full funding policy

Answer 13

The government tries to meet the whole of the deficit through borrowing.
The alternative to full funding is to print money.

Question 14

2 Components to investment in a foreign country

Answer 14

• return achieved by the investment as measured in the local currency
• profit/loss from exchange rate movements

Question 15

Institutional cashflow effects on bond prices

Answer 15

If institutions have an inflow of funds because of increased levels of savings, they are likely to increase their demand for bonds.
Changes in investment philosophy can also affect institutional demand for bonds.

Question 16

2 Important effects of real interest rates

Answer 16

• 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.
• rate of return required by investors should be lower, so the present value of future dividends will be higher.

Question 17

Inflation

Answer 17

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.

Question 18

3 Indirect effects from inflation

Answer 18

• 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
• Investors expecting high inflation may also expect the government to increase real interest rates in response.
• Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Might result in an increase in equity investment, as equities should provide a hedge against inflation.

Question 19

Equity risk premium

Answer 19

Additional return that investors require from equity investment to compensate for the risks relative to the risk-free rates of return.

Question 20

Effects of a weaker domestic currency

Answer 20

• makes exports more competitive (increase profits, and profits earned in other countries are more valuable when converted)
• makes imports more expensive (bad for corporate profits to the extent that firms cannot pass higher costs of imported raw materials to customers)
• Higher costs of imported materials may lead to inflation, (however, if manufactured imports are more expensive, the domestic market share should increase)

Question 21

Economic influences on the property market (3)

Answer 21

• occupation market
• development cycles
• investment market

Question 22

occupation market

Answer 22

demand for property for occupation by businesses

Question 23

development cycles

Answer 23

supply of newly completed property developments

Question 24

investment market

Answer 24

supply and demand for properties as investments.

Question 25

Property: Effects of Development time lags

Answer 25

Peak of the property development cycle does not coincide with the peak of the business cycle.
time lag between gaining consent for a property development, and completing the construction on it, frequently results in a substantial amount of the supply of stock coming into the market as the economy slows down.
A slow down in the economy, coupled with rising real interest rates, is harmful to the property development industry.

Question 26

Characteristics of supply/demand for the property occupation market

Answer 26

• fixity of location
• high transaction costs
• segmented markets

Question 27

Cost-push infaltion

Answer 27

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.

Question 28

3 Possible sources of cost-push inflation

Answer 28

• higher import prices due to a weakening of the domestic currency
• higher import prices for some other reason (eg rise in the oil price)
• higher wage demands not met by productivity increases

Question 29

Quantity theory of money: Identity

Answer 29

M x V ≡ P x Y

• M is the nominal money supply
• V is the velocity of circulation
• P is the price level
• Y is the number of transactions

Question 30

Quantity theory of money: Interpretation

Answer 30

If we assume that V (velocity of money) and Y (number of transactions) are fixed - as may approximately be true in the short run - then the quantity theory of money suggests that:

an increase in the (nominal) money in circulation will cause an increase in prices.

Question 31

Demand-pull inflation

Answer 31

Refers to a situation in which there is excess demand with the economy so that firms are able (and more likely) to increase their prices.
As a consequence, the general level of prices may be pulled up.

Question 32

3 Distinct ways in which increases in short-term interest rates can influence yields on either short- or long-dated bonds

Answer 32

• Higher short-term interest rates directly increase short-term bond yields because they should always be similar to each other.
• Expectations of higher future short-term interest rates can increase long-term bond yields according to the expectations theory of the yield curve.
• Higher short-term interest rates can reduce inflationary expectations and so tend to reduce long-term yields.

Question 33

Why does selling Treasury bills increase short-term interest rates?

Answer 33

To sell more Treasury bills, the central bank needs to reduce their price.
This increase in their “discount” corresponds to a rise in one of the measures of short-term interest rates.
Rates on other money market instruments will move broadly in line.

Question 34

Why selling Treasury bills might cause bond yields to rise

Answer 34

To sell more Treasury bills, the central bank needs to reduce their price.
This makes Treasury bills seem relatively attractive compared with bonds.
Bond prices may subsequently fall and yields rise.

Question 35

Why printing money results in lower short-term interest rates

Answer 35

More money in circulation makes more money available for placing on short-term deposit.
It is therefore easier for banks to attract deposits.
Consequently, they can reduce interest rates on deposits.

Question 36

Why printing money increases expectations of inflation

Answer 36

The quantity theory of money tells us that there is a direct relationship between the money supply and the level of prices.
More money chasing the same quantity of goods must cause prices to rise.

Question 37

Why printing money causes bond yields to rise.

Answer 37

The increased expectations of inflation will make investors demand higher nominal yields in order to maintain the required level of real yields.