Chapters 20 and 21: Economic and other influences on investment markets Flashcards
Key factor affecting the supply of government bonds and hence the level of the government bond market
The size of the government’s fiscal deficit and how it decides to fund it.
If the government adopts a full funding policy by issuing bonds or bills, the extra supply of stocks at certain durations will cause downward pressure on the price of those bonds.
Alternatively, if the government decides to fund the deficit by printing money, this could have inflationary consequences, causing upward pressure on bond yields and downward pressure on the price of bonds.
Key economic factor affecting the demand for government bonds
Investors EXPECTATIONS of the level and riskiness of returns.
For government bonds, these will reflect investors expectations of:
- future real short-term interest rates,
- future inflation,
- future uncertainty relating to inflation, the inflation risk premium
- the exchange rate.
How might an expected cut in future real short-term interest rates over the next couple of years affect bond yields and hence bond prices
Short-dated bond yields should fall as they are very similar to short-term interest rates.
This is because short-dated bonds and money market instruments are substitute goods.
Therefore the price of short-dated bonds should rise.
However, in the longer term a cut in future real short-term interest rates could be inflationary.
As a result, longer-dated bond yields may rise. Therefore the price of longer-dated bonds should fall.
If sterling was expected to depreciate against the US dollar, how would this affect the relative levels of the US and UK bond markets?
If Sterling was expected to depreciate this would mean that any income and capital earned in US dollars would be worth more when converted back into sterling.
This would make US bonds relatively more attractive to UK investors, and UK bonds relatively less attractive to US investors.
However, you should also consider the underlying cause of the depreciation of sterling against the US dollar.
E.g. in the short term, the depreciation may have occurred in response to a cut in UK short-term interest rates.
In the longer term the depreciation may reflect the purchasing power parity path of the exchange rate, offsetting differences in US and UK inflation.
3 Other factors affecting the demand for government bonds
- Investors’ income which is mainly driven by the level of institutional cashflow
- Investors’ preferences, as dictated by factors such as their liabilities, tax rules, risk appetite, fashion, education and the political climate
- the price of alternative domestic and overseas investments
What additional factors affect the SUPPLY of corporate bonds, relative to government bonds
- the relative attractiveness of raising finance through corporate bond or equity issues, e.g. if the equity market is depressed, it may be easier to raise finance through corporate bond issues, increasing the supply and reducing the price.
What additional factors affect the DEMAND for corporate bonds, relative to government bonds
influenced by investors’ expectations of the extra yield that can be earned on corporate bonds relative to the extra risk involved.
If investors believe that the extra yield is greater than the additional marketability and security risks involved, then corporate bonds will seem relatively more attractive.
Key factors affecting the SUPPLY of equities
numbers of:
- new listings
- rights issues
- demutualisations
- share buy-backs
- privatisations
- nationalisations
What influences the number of new listings? (equities)
the buoyancy of the economy.
They may be higher during times of higher economic growth, since there will be more startup companies and it will be easier to raise finance.
What influences the number of rights issues? (equities)
the buoyancy of the economy.
the relative attractiveness of raising finance through corporate bond or equity issues.
Key economic factors affecting the DEMAND for equities
Investors’ expectations of the level and riskiness of returns.
Expectations of:
- economic growth
- real interest rates
- inflation
- the equity risk premium
- the exchange rate
How might expectations of poor economic growth affect the equity market?
Dividend growth moves broadly in line with economic growth.
Therefore expectations of poor economic growth might cause the price of equities to fall.
Poor economic growth may also affect the perceived riskiness of equities, increasing the equity risk premium and hence the return that investors require to invest in equities.
This would reduce the price that investors are willing to pay for equities.
How might expectations of low real interest rates affect the equity market?
Low real interest rates should stimulate economic activity, increasing companies’ profits, resulting in higher expected dividend growth causing equity prices to rise.
Also, the real rate of return required by investors may be lower, resulting in a higher present value of price of future dividends.
How might expectations of inflation influence the equity market?
In general, equity prices should be relatively indifferent to inflation, since equities are a real investment.
However, high inflation is often accompanies by high interest rates, which may be seen as unfavourable for economic growth.
Alternatively, in times of high inflation, demand for equities may rise, as investors seek real investments to hedge against inflation risk.
3 other factors affecting the demand for equities.
- investors’ income, which is mainly driven by the level of institutional cashflow
- investors’ preferences dictated by factors such as their liabilities, tax rules, risk appetite, education, fashion and the political climate
- the price of alternative domestic and overseas investment.
