Chapter 12: Behaviour of the markets Flashcards
Short-term interest rates are determined largely by government policy, as the government balances… (3)
- the need to control inflation
- the need to encourage economic growth
- management of the level of the exchange rate.
6 Main factors affecting bond yield
- Inflation
- Short-term interest rates
- Institutional cashflow
- fiscal Deficit
- Exchange rate
- Returns on alternative investments, both domestic and overseas
Level of the equity market is determined by ….
investors’ expectations of future corporate profitability and the value of those profits.
Main influences on the level of equity (5)
- expectations of real interest rates & inflation
- the real level of economic growth in the economy
- investors’ perceptions of the riskiness of equity
investment - equity risk premium (ERP)
- expectations of currency movements
Other factors influencing the level of equity in the market (6)
- POLITICAL climate
- ALTERNATIVE investments
- TAXATION
- institutional cashflow
- OVERSEAS equity markets
- SUPPLY factors
How does demand and supply affect price?
What is the demand elasticity for most investments and why?
- Increase demand => Increase price
- Increase supply => Decrease price
- Demand for most investments are very price elastic due to the existence of close substitutes
Key economic factors affecting the property market
- economic growth
- real interest rates
- inflation
- institutional cashflow
- exchange rates
Inelastic supply of property is caused by: (5)
- 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
Inflation effects on bond yield
-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
Short-term interest rate effects on bond yields
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.
Fiscal deficit effects 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.
Full funding policy
-The government tries to meet the whole of the deficit
through borrowing.
-The alternative to full funding is to print money.
2 Components to returns from investments in a foreign country
- return achieved by the investment as measured in the
local currency - profit/loss from exchange rate movements
Institutional cashflow effects on bond prices
-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.
2 Important effects of real interest rates on the equity market
- 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.
Inflation effect on equity market
-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.
3 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
- 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.
Equity risk premium
Additional return that investors require from equity investment to compensate for the risks relative to the risk-free rates of return.
Effects of a weaker domestic currency
- 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)
Areas of economic influence on the property market (3)
- occupation market
- development cycles
- investment market
occupation market
demand for property for occupation by businesses
development cycles
supply of newly completed property developments
investment market
supply and demand for properties as investments.
Property: Effects of Development time lags
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.
