Investment principles and risk

Our audiovisual presentation provides an introduction to this chapter.

I...

Shortened demo course. See details at foot of page.

... classes, key economic indicators and the impact on monetary and fiscal policy.

Governments are able to influence economic and financial conditions through their fiscal and monetary policies. In recent years a lot of the responsibility for managing monetary policy has been tendered out to central banks such as the Bank of England. Since the economic crisis, however, this trend has reversed and some Governments have had to become more involved in financial issues, most notably through bank bailouts.

In our current climate of ultra-low interest rates, the central bankers’ influence on the supply of money and control of inflation is greatly restricted.  More of the responsibility for economic management falls onto t...

Shortened demo course. See details at foot of page.

...sp;which can lead to a boom before an election and a cooling down afterwards - has mainly been curtailed where central banks have been granted independence.

SInce 1992 the Bank of England has had a greater influence on monetary policy, and since May 1997 the Bank’s Monetary Policy Committee has had operational control of interest rates.

The European single currency is run by the European Central Bank, which has vigorously demonstrated its independence under notable political pressure from one of its main constituent countries Germany.

What are the three things that Government policy can affect?

Answer : Purchase course for answer

There are many other external factors which will have an impact on the way that asset classes behave.

Foreign Affairs

International relations have become increasingly important as economies and markets become increasing financially interdependent. The events happening in other countries can have a major impact on investor and market sentiments in the UK and there are a number of examples of this in recent history:

The terrorist attacks in New York and Washington DC on September 11 2001 created serious concerns about a global recession and prompted major central banks to cut rates rapidly

The build up to the Second Gulf War had several effects on world markets. Both the US$ and sterling weakened against the Euro, and safe havens such as gold staged a strong rally. The equity markets were flat while investors waited for the results of UN inspections and resolutions, and there was generally a downward spiral in confidence

The rapid growth seen in the Chinese economy has had a number of different impacts in the global economy. The rise in demand for raw materials was blamed for a huge rise in commodity prices. The Chinese Government then only allowed a gradual revaluation of its currency against the US$, whilst at the same time concerns grew about the value of its own huge US$ reserves. In 2015 and during 2016 China’s stock market crashed and the Chinese government have had to introduce measures to help reverse the damage

The Euro crisis of 2010/11 followed the credit crunch when countries that were too weak to fund bank bailouts or fiscally over-stretched countries needed bailouts from new mechanisms put in place by other Eurozone members. As these were unacceptable to Germany, the European Financial Stability Facility followed by the European Stability Mechanism were created on guarantees from member states. However, the lack of firm proposals to reschedule the debts of countries too weak to repay them led to spells of nervousness in markets coupled with a weakness of the Euro against the ...

Shortened demo course. See details at foot of page.

...ome left behind if they do not ensure sufficient research and development is carried out to accommodate future changes, not to mention ensuring that its workforce are sufficiently skilled to handle future change.

Of course, technology can create new industries very quickly from almost nothing.  For example, would we have imagined 20 years ago that so many people would personally own their own computer and mobile telephone? Of those companies that were present at the start of each technological boom and survived, many are now multi billion pound businesses.

A country's capacity for technological change is often measured on the proportion of national output (GDP) that is invested in research and development (R&D). Technical innovation is only part of the story and the key to economic success is how new technology is adopted and utilised. This will depend to some extent on the skills and education of the workforce.

Technological change can create fast-growing industries and transform existing ones. Inward investment by multinational companies is also partly responsible for the transfer of new technologies internationally.

Successful incorporation of new technology into all aspects of a firm’s business operations has led to those firms gaining a competitive edge over their rivals. Some examples of these are listed below.

Industry

Development

Mobile Telecoms

In the 1990s telecoms were the new industry and created lucrative investment opportunities that were exploited by such companies as Nokia and Vodafone.

Telecoms (data messaging)

The explosion of data messaging (including internet access) demonstrates how an existing industry can be transformed by rapid technological change.

E-commerce

Retailing and wholesaling via the internet has opened new markets and has radically changed the way in which consumers purchase goods. The biggest online retailer in the world is now Amazon.

Why do financial bubbles occur?

Answer : Purchase course for answer

Technological advances and international trade are creating a truly global economy where consumers can buy products from anywhere in the world. Developing markets have been assisted by investment of capital and technology from developed countries. This has had the effect of creating efficiencies for their industries and raising the standard of goods and services produced so that they can be sold on the global ma...

Shortened demo course. See details at foot of page.

...estor confidence

A change in leadership or government can have both positive and negative impacts

Some countries will have less developed political, legal and regulatory frameworks in place and investors may not have the same level of protection as they would have if they invested solely in the UK.

Why has globalization led to a decline in manufacturing in the UK?

Answer : Purchase course for answer

In addition to individual businesses, national, regional and even the world economies encounter business (or economic) cycles. In recent years the length of these cycles has typically increased - often up to 10 years - and there will often be short term fluctuations during these cycles, usually caused by changes in economic policy. Business cycles are important to investors as they will have an effect on asset prices.

Business cycles tend to be measured between one period of the economic cycle to the next time that it occurs e.g. recession through the cycle to recession, or boom through to boom.

The four stages of the economic cycle are:

Recession

Recovery (expansion)

Boom

Slowdown (contraction)

Where an economy enters its boom phase, it will be growing at its most rapid rate within the business cycle. Conversely where it enters recession, it will have reached its lowest level of growth. The periods of the cycle do not have to bear any relationship to each other in terms of time. For example, a very short period of recession can follow a long period of economic recovery and vice versa.

Where an economy reaches its lowest level of growth, there will be a requirement to define when it has actually achieved this point. For this reason, recession is technically defined as at least two successive quarters of declining gross domestic product (GDP).

The business cycle affects financial markets in the following ways:

Recovery/ Expansion

Boom

Slowdown/ Contraction

Recession

Interest rates

Usually keep low to encourage spending

Interest rise to keep economy growing

Interest rates remain high in order to slow economy gradually

Interest rates usually fall as the economy has slowed down too much

Inflation

Starts low but as more goods and services sold more pressure...

Shortened demo course. See details at foot of page.

...lue of all goods and services produced each year and is compiled on a quarterly basis.

When the level of GDP falls compared with the previous quarter, the economy is considered to be slowing down or contracting.

Where there are two successive quarters of falling GDP, the economy is said to be in recession.

Where GDP increases compared with the previous quarter, the economy is said to be expanding.

The current level of GDP for the UK economy can be found on the Office for National Statistics website  ( www.statistics.gov.uk ).

A vital component of GDP is Government spending on current and capital expenditure (the costs of running the country). The Government’s revenue comes from the taxation of businesses and private individuals, and the difference between the revenues received and Government expenditure is known as the public sector net cash requirement (PSNCR) . In the UK the Government typically has a borrowing requirement as there is a deficit between revenues received and the cost of running the country.

The PSNCR indicates the extent to which the Government needs to borrow from other sectors of the economy and overseas in order to finance the difference between expenditure and receipts.

If the economy is in recession, tax revenues will fall and spending on unemployment will increase, therefore the PSNCR is likely to grow

If the economy is expanding, tax revenues will rise and benefit costs will decrease meaning that PSNCR will decrease

The economies of the world are all at different stages in their economic, business and investment cycles at any given time. However, with increased globalisation and international trade changes to economies in different countries, especially USA, there will be an impact on UK financial markets.

What do the letters GDP stand for?

Answer : Purchase course for answer

As we said earlier the Government uses policy instruments, including taxes and regulations, to help achieve its objectives. In this section we will look at how monetary and fiscal policy contributes to this.

Fiscal policy

This involves varying total public sector expenditure and/or the overall level of taxation to influence the level of demand in an economy.

Fiscal policy is Government budgeting, as they add up all the income from tax revenues, national insurance and other sources and then work out their expenditure plans for all areas including health, welfare, education, defence, interest and debt repayment.

Having completed this, they will arrive at a surplus or a deficit. A deficit will drive a public sector net borrowing requirement, or in other words the amount needed to balance the Government’s books.

This can be met in one of three ways, though usually ends up as a combination of them all:

Borrow funds by raising gilts or other loans Shortened demo course. See details at foot of page.

...ion by increasing short term interest rates.

This should in turn increase longer term interest rates

Leading to a fall in asset prices

Reducing wealth and the willingness to borrow and spend

This reduces supply and demand

Businesses will invest less and reduce expectations of sales and profitability

The Bank of England needs to be careful in regard to its expectations of future interest rates, as the expectations reached by the financial markets can intensify the impact of monetary policy.

The first rate cut after a period of rising rates may lead financial markets to expect further cuts and this in itself can lead to cuts in longer term rates

The converse can be said for rate rises

You should note that cash products linked to sterling LIBOR ended in 2020 and the transition from LIBOR to SONIA (sterling overnight indexed average rate) should be complete by the end of 2021. 

Who controls UK monetary policy?

Answer : Purchase course for answer

There are two main measures of the money supply that are monitored by the financial markets:

M0 (narrow money or monetary base) - t his includes notes and coins in circulation, together with operational deposits that banks hold at the Bank of England

M4 (broad money) -  i ncludes notes and coins in circulation plus instant access and deposit accounts held by UK residents with UK banks and building societies

Money supply is the amount of money available within the economy to purchase goods and services. The amount of money in circulation provides an indication of the strength of consumer demand by measuring changes in the cash base.

The rate at which banks lend to each other gives the Bank of England’s Monetary Policy Committee an indication of the demand for credit at the prevailing rate of interest.

In principle, less money in circulation can reduce inflation. However, this is a rather simplistic view in the modern environment as technological changes have ...

Shortened demo course. See details at foot of page.

...ts. The sellers of the assets have more money that they can now spend, or they may purchase other assets.

Spending money in the economy on goods and services or investing in assets increases the value of companies and drives the economy forward. In addition, banks will find themselves holding more reserves, which allows them the opportunity to boost their lending to consumers and businesses and thus further increasing spending in the economy.

That said, if banks are concerned about their financial health, they may prefer to hold the extra reserves without expanding lending.

The idea of quantitative easing is that extra money works its way through the economy, resulting in higher spending and therefore growth.

The combination of low interest rates and quantitative easing enables governments to borrow money at very low rates of interest which in turn keeps government interest payments on the national debt low.

What is known as M0 or narrow money?

Answer : Purchase course for answer

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. In other words, inflation represents the erosion of purchasing power of money.

Inflation is usually measured by the inflation rate - the annualised percentage change in general price index over a period of time. The traditional measure of inflation in the UK for many years was the Retail Prices Index (RPI) but in 2003 this changed to the Consumer Prices Index (CPI). The RPI figures are still published but are no longer designated as a National Statistic. In 2017 the CPI including owner occupiers’ housing costs (CPIH) became the main measure of inflation used by the ONS. This is seen as being more comprehensive as it includes housing...

Shortened demo course. See details at foot of page.

... value of the initial capital invested being eroded.

An unexpected change in the rate of inflation can impact on the value of fixed interest securities. Prices tend to rise on expectations of falling inflation and fall if inflation appears to be speeding up.

Indexed linked gilts that have their income and redemption values adjusted in line with inflation can give some protection.

Equities

Equities are usually seen as a good hedge against inflation because efficient companies will increase profits at least in line with inflation.

Rising company profits will lead to increased dividends and/or growth in the capital shares of the company.

Historically only equities have consistently grown in real terms over the longer term.

What is the lead measure of inflation used by the ONS?

Answer : Purchase course for answer

Interest is paid on deposits and fixed interest investments as well as being charged on borrowing. They are basically payments made for the use of someone else’s money.

An investor who holds onto their cash will not benefit from any interest payments

Once the money is deposited, the bank will pay interest to the depositor for the use of the funds elsewhere

The bank will lend money to individuals and companies who will pay interest to the lender. The price for being able to borrow is the interest rate charged on the loan

The rate of interest paid or charged will depend on the time factor of the investment and the risk element.

Money depos...

Shortened demo course. See details at foot of page.

..., the capital value of fixed interest securities will generally fall, allowing them to reflect the higher interest rates available on cash.

When interest rates fall the opposite is true.

Equities

Equities generally benefit from lower interest rates because companies are usually more profitable if the cost of borrowing is low and demand for products and services is high.

Increased profits may lead to increased dividends to investors. This makes future dividend streams more valuable and this in turn pushes up the share price.

What is the relationship between fixed interest securities and interest rates?

Answer : Purchase course for answer

An exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in terms of another currency. For example, in the UK the dollar exchange rate means the number of dollars ($) one pound (£) can buy.

The foreign exchange markets enable the currency used by one country to be purchased and paid for with another country’s currency, thereby allowing international trade.

Goods exported by the UK create a demand for sterling from foreign buyers and this increases the supply of foreign currency in the foreign exchange market

Goods imported into the UK create domestic demand for foreign currencies with which to purchase goods from abroad, and this decreases the supplies of foreign currencies on the foreign exchange markets

Real exchange rates are the effective rates of exchange between two countries that have been adjusted for inflation. This measures the price of domestically produced goods relative to the price of foreign goods taking into...

Shortened demo course. See details at foot of page.

...domestic goods and services become more costly compared to foreign goods, thus having a negative impact upon domestic production. If it falls however, domestic goods become less expensive and demand for them rises

Some countries may gain an advantage in international trade if they manipulate the value of their currency by artificially keeping its value low. In theory this would increase the competitiveness of their exports. It is argued that China succeeded in doing this over a long period of time.

Effect on domestic shares

Indicator

Rise in value of pound

Fall in the value of pound

Profitability of exports

Profits would reduce

Profits would increase

Share price of major exporters

Share prices would probably go down

Share price would increase

Value of profits earned overseas translated to sterling

Profits converted back to sterling would reduce

Profits converted to sterling would increase

Firms that would benefit

Firms that rely on imports of raw materials or components

Exporters

What kind of exchange rate mechanism operates in the UK?

Answer : Purchase course for answer

The Balance of Payments records one nation’s transactions with the rest of the world and is calculated by adding up all the receipts that come into the UK and deducting the payments made in sterling leaving the UK.

The Balance of Payments can effectively be broken down into two parts – the cur...

Shortened demo course. See details at foot of page.

... of factors such as import quotas for sectors, exchange rate controls making it harder and more costly to import, as well as encouraging investment in the UK to increase the capital account. 

Into which two parts is the balance of payments for a country broken down?

Answer : Purchase course for answer

The economy is driven by investment in UK companies, enabling them to expand and attract investments to improve their share price and profits.

Investment depends on market confidence as well as individual and sector performance and this confidence often stems from Government decisions and expectations in respect of the econom, as we have seen in this chapter.

There are two markets available to investors in the UK that allow investment to take place, namely the Primary Market and the Secondary Market .

Primary Market

This is...

Shortened demo course. See details at foot of page.

...ts to allow investors that have already invested to trade their investments to another party.

The secondary market is required to run alongside the primary market, as without the outlet to realise an investment there would be little incentive for anyone to invest in a Government or company in the first place.

This provides the investor with liquidity but is dependent on finding a buyer for the investment in question. 

What are the two markets in the UK economy that allow investment to take place?

Answer : Purchase course for answer

Your results and the estimated s...

Shortened demo course. See details at foot of page.

...ate.

Estimated study time 4.1 hours