Investment principles, markets and environment

Introduction

Investors should be alert to political changes and the impacts that these may have on the economic environment. Government policies have both a direct and an indirect affect on the economy.

Government policies could revolve around:

Decisions on interest rates and the money supply

Taxation

Spending

National debt management

Exchange rate policies and currency agreements

International treaties or conflicts

Industry regulation.

All of the above could ultimately affect business competition, economic cycles, inflation, interest rates and the currencies of an economy.

It is worth discussing the basics of how Government economic objectives are initially formulated. These will ultimately decide the more specific policies that impact upon the economy and markets as a whole.

Government economic policy objectives

A high and stable level of employment

This is considered desirable within an economy but it is virtually impossible nowadays to have zero unemployment. It is often felt that for an economy to run efficiently and flexibly in the face of change, there will be individuals who will be undergoing periods of unemployment whilst in the process of changing to roles more suited to the current environment.

A low and stable rate of inflation

Regarded as an essential objective for economies these days, due to the high political and economic costs associated with rising prices. It is commonly seen as a necessary prerequisite for achieving consistent economic growth.

A high rate of economic growth

A high rate of economic growth provides for the increases in the living standards of the general population. The rate of growth should be comparable to rates of growth of similar economies overseas.

A satisfactory balance of payments

A satisfactory balance of payments usually aims to achieve an equilibrium or slight surplus on international trade over the long term. Equilibrium indicates that a nation is able to pay its way in international terms. A surplus on the current account indicates that the country’s stock of overseas assets is increasing or that its stock of overseas net liabilities is decreasing.

Even distribution of wealth

This could either refer to individuals or be on a regional basis. For example...

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In more recent times, we have experienced the effect of the “credit crunch” on nations around the world to the extent that sub prime or “toxic” debt emanating from the US, has spread around international markets, particularly through banks as they have purchased and sold debt instruments and exposed themselves to the risks of such low quality borrowing. The ultimate effect of this crisis has been a loss of trust between the banks themselves and an unwillingness to borrow from or lend to each other to create a satisfactory level of credit to maintain a stable and growing economy. Equity markets around the world have also reacted negatively as more and more banks exposed to these sorts of debts at high levels, have fallen into financial trouble, lacking sufficient capital to cover the increasing level of debt default whilst still maintaining usual operations. Governments internationally have sought to shore up the holes in bank balance sheets by providing taxpayers’ funds to re-capitalise banks but the impact of this move may become clearer in the coming months or even years, as markets worldwide struggle to come to terms with their respective economies sliding into recession.

Finally, political conflict or unrest could seriously destabilise confidence in a country which could lead to an otherwise relatively stable economy becoming unattractive to investment. For instance, the terrorist attacks on the USA in 2001, caused widespread concern about a worldwide recession. This prompted the major central banks to drop interest rates to bolster demand.

Regulation

Political influences and policies to regulate financial services should ideally enable markets to operate within structured guidelines. This can in turn, allow consumers to become more educated and operate within an environment of confidence and protection. In addition, strict regulation will reduce the risks of financial crime. A balance needs to be drawn between such regulation and the continued ability of markets to operate freely.

In recent years in the UK, there has been considerable regulation imposed upon the financial services industry often in reaction to events that have resulted in losses to consumers.

There are a number of social factors that influence investment markets.

One major factor is the distribution of the age of the population. Where there is a high distribution of younger people, this will be reflected in an increased workforce with the obviou...

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Inflation

Inflation can be described as a persistent tendency for the general level of prices to rise.

Inflation will affect all investments to a greater or lesser extent. At modest levels, it does not necessarily cause problems to an economy. However, if rises are persistently high, they can have a damaging impact on the returns from investments as their real value is eroded. Unchecked, inflation can cause an economy to “overheat” as demand outstrips supply and prices spiral. In addition, a country with high inflation can have any advantage of a competitive nominal exchange rate wiped out if the rate of inflation is high and prices continue to increase.

Equities have traditionally been seen as a good hedge against inflation because income and capital values can be anticipated to increase in line with the economy. These investments are a good example of being able to understand the difference between nominal and real rates of return (simply put the rate of return minus inflation). Average annual real returns in equities from 1957 to 2007 were around 7.2% compared to 2.4% for gilts.

In the UK economy in the last 15 or so years, the control of inflation has been a key priority of the Government and its impact can be felt over the long term. Therefore, if adequately managed, it can be the precursor to sustained periods of economic stability. If not dealt with properly, then the effect on businesses within the economy can be severe. Some examples of the associated problems of inflation may be:

Constant re-pricing of goods and services

The inability to enter into long term contracts due to the lack of certainty over profit levels

Loss of international competitiveness

Increased wage demands from workers and any associated industrial action which affects the ability of businesses to sustain productivity and therefore profit making capability.

The opposite of inflation is deflation. This would usually be accompanied by declines in output and demand as falling prices can give the incentive of delaying investments or business purchases. Disinflation is the term used for the drop in the rate of inflation.

Interest rates and money supply

Interest rates

Changes in the level of interest rates have a profound effect on the economy and are used in the UK as a tool to control inflation targets.

Changes to interest rates can have some important consequences on the economy as a whole, as well as financial markets.

If a decision is made to reduce the level of interest rates and it is agreed that this will become a trend over the medium term, then the likelihood is that the economy will begin to expand and output increase. This is because the cost of borrowing reduces allowing both consumers and businesses to purchase more. This will result in increased demand for products and services. As a result, company profits will generally be greater as not only the cost of borrowing reduces but al...

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Exchange rates

Changes in exchange rates can influence investment holdings in two ways:

Firstly there will be an obvious connection with an overseas company.

Secondly, there will also be an indirect impact on companies listed in the UK who by the nature of their business are involved in import or export activity or, have overseas operations that earn profits abroad.

It is the “real” exchange rate that decides the long term competitiveness of a country. This is the nominal exchange rate altered to account for the effects of inflation both at home and abroad.

Exchange rates can be fixed between countries or can float against their values as determined by the foreign exchange markets.

Where the latter occurs, the exchange rates are often determined by the gap between the interest rates of each country and by expectations of future movements in these rates.

Effect on foreign investment holdings

The exchange rate measures the level of currency that can be bought for one unit of another currency.

A rise in the pound could result in more of a foreign currency being bought for the £1. For example the pound might appreciate against the US dollar. $1.60 could have been exchanged for £1 two months ago. Now the £1 may be worth $1.85.

Likewise a fall in the value of the pound could result say in a conversion rate of $1.85 for £1 today and in two months time that rate falls to only $1.30 for £1.

In this example, when the pound rises in value in relation to the US dollar it reduces the return to UK investors from shares that they hold in the USA. The opposite effect will happen where the pound falls against the dollar.

International Competitiveness

The real exchange rate determines long term competitiveness

If a fall in the pound causes UK prices to rise faster than foreign trading countries, any competitive advantage from that depreciation can be lost

Alternatively, an appreciation in the pound may have no effect on the UK’s long term competitive position if is underpinned by lower inflation in the UK than elsewhere in the world

If the real exchange rate rises, 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.

Taxation

The total level of taxation will dictate the level of funds that remain for an investor to invest. It is also an important measure of the success of an investment and its overall returns. If returns are favourable, but taxation incurred by the investment is punitive, returns can be dramatically cut.

Some businesses and individuals will be provided with tax incentives to invest. ISAs, EISs and VCTs for example, encourage individuals to invest in companies. This could lead to much needed sources of capital otherwise unavailable, being provided to companies and allowing them to expand.

Demand

The demand for a product is the level at which consumers wish to buy it at a given price. There are a number of factors that affect demand:

Price

Consumer income

Level of demand for alternative products

Demand for other products or services being used simultaneously

Consumer taste.

Demand curve

The demand “curve” illustrates the level at which consumers are prepared to purchase a product or service at different prices. The curve in its simplest form does not take into account other factors that could affect demand such as the consumer’s income or personal tastes.

The following diagram illustrates how the demand curve would be affected by a decrease in price from P1 to P2:

Reducing the price will persuade consumers to buy more of the product or service moving quantity sold from Q1 to Q2. Continuing with the above diagram, increasing price would reduce the quantity sold.

The demand for a product is said to be elastic if a small price decrease results in a large increase in demand. The is illustrated in the following diagram:

Conversely, a steep demand curve would illustrate inelastic demand as illustrated in the following diagram:

Unitary elastic means that a given change in price reflects the same level of change in demand. The demand curve is represented by a 45 degree line.

A shift in the demand curve occurs because of a change in factors that affect demand other than price such as consumer preferences, income, competition, taxation etc. A movement of the demand curve either to the right or to the left will result in a new set of relationships between demand and price. A movement along the demand curve however, is only a change in quantity demanded relative to price movements as al...

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Producers have to operate efficiently to meet customer needs

Producers have an incentive to innovate and find lower cost methods of production

Producers have to organise their business to keep down costs per unit produced

Consumers receive better value through lower prices, releasing capital for other expenditure or savings.

Monopolies and barriers to market entry

Monopolies occur where there are high entry barriers to businesses that want to start trading in a particular market. The main barriers to entry are:

Economies of scale – the size of the production needed to enter the market means that costs of entry are too high relative to likely returns

Government regulations – the government only allows certain organisations to function in the market

Patents – firms can gain at least a temporary monopoly following the launch of products protected under patent

Control over essential resources – some producers have a monopoly over certain raw materials or transport facilities.

Such barriers to entry will inevitably result in much reduced competition and commonly a poor use of resources. Consumers will often be disadvantaged by higher prices and choice even though in certain instances, a monopoly could be justified due to the nature of the risk being taken on by the supplier.

Features of a monopoly:

The main features or characteristics of a monopoly are:

There is only one supplier

There are no clear substitutes for the product or service

There are high barriers to entry.

Oligopolies are markets that contain a few large producers. It is often anticipated that oligopolistic producers will collude about pricing, production and market share. Where such collusion operates formally, the companies involved are said to belong to a cartel. In such cases governments often have legislation to intervene where competition is being stifled in this way.

Full employment

Where an economy contains full employment, there is no cyclical unemployment and the only types of unemployment are frictional and structural. The rate of unemployment in these circumstances is known as the natural ...

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Expansion – sales start to go up, increasing GDP and unemployment decreases

Boom – business are working at optimum capacity and unemployment is at its lowest. GDP expands rapidly

Slowdown – sales fall and unemployment starts to rise with a slowing down in GDP growth.

Impact of Government economic Policy

In many western economies including the UK, Government economic policy now concentrates on inflationary control. Fiscal policy has become less significant as the primary method of controlling economies as the influence of capital markets becomes increasingly more powerful. If traders wish to support a national economy, then vast sums can be brought into a country via the markets. Equally, if they disapprove of a regime, then funds can be quickly moved away. There is still a part for fiscal policy to play in economic management however. In the European Union for example, it is the only real method of control that member countries have in managi...

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Lender of Last Resort

The central bank can use its resources to offer unlimited funds to banks that face a liquidity crisis but are fundamentally solvent. This is a role of the Bank of England but not the European Central Bank.

Banking Supervision

Monitoring of key capital and lending ratios to ensure effectiveness of management. In addition, the Basle Accord (1998) required minimum capital as a percentage of risk weighted assets to be held by banks. This requirement has been refined and new capital requirements (following Basle 2) are in place.

In 1998, UK banking supervision passed from the Bank of England to the Financial Services Authority.  Following the implementation of the Retail Distribution Review recommendations, from 1 January 2013 supervision of Banks has now passed to the Prudential Regulation Authority (PRA).