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Behaviour of the markets (Conventional bond yield curve theories (LIME)…
Behaviour of the markets
Key risks of asset classes for an investor
Conventional government bonds
inflation risk
Corporate bonds
default, inflation, marketability and liquidity risk
Marketability and liquidity risks n/a if investor operates a 'buy and hold' strategy, due to having close matching between A and L cashflows
Equities
Non-payment of dividends, dividend/ price volatility, marketability, liquidity and contagion risk (driven by market sentiment)
The general level of the market of an asset class
the interaction of buyers and sellers, i.e. supply and demand
Factors affecting the demand for any asset class
Investors' expectations for the level of returns on an asset class
Investors' expectations for the riskiness of returns on an asset class
Economic influences on short-term interest rates
Economic growth
low interest rates => increased consumer and investment spending => economic growth
Inflation
Low interest rates => increased demand for money, which may be met by increased money supply => higher inflation
Exchange rates
Low interest rates relative ti other countries => less investment from international investors => depreciation of domestic currency
Conventional bond yield curve theories (LIME)
Liquidity preference theory
investors prefer liquid assets to illiquid ones. Therefore, investors require a greater return on longer-term, less liquid stocks. This causes the yield curve to be more upward sloping/ less downward sloping than suggested by pure expectations theory alone.
Inflation risk premium theory
the yield curve will tend to be more upward sloping/ less downward sloping than suggested by pure expectations theory alone because investors need a higher value to compensate them for holding longer-dated stocks, which are more vulnerable to inflation risk.
Market segmentation theory
yields at each term to redemption are determined by supply and demand from investors with liabilities of that term, e.g. banks (short-term bonds) and pension funds (long-term bonds). The two areas of the bond market may move independently.
Expectations theory
the yield curve is determined by economic factors, which drive the market's expectations for future short-term interest rates.
Economic influences on short-term government bond yields
Short-term government bond yields are closely related to short-term interest rates, because short-term government bonds and money market instruments are close substitutes
Economic influences on long-term government bond yields
Supply
the government's fiscal deficit and funding policy
Demand
Expectations of future short-term real interest rates
expectations of inflation
the inflation risk premium
the exchange rate, which affects overseas demand
institutional cashflow, liabilities and investment policy
returns on alternative investments
other economic factors (e.g. tax, political climate).
Factors affecting the yield gap between government and corporate bonds
Differences in security
Differences in marketability and liquidity
the relative supply of government and corporate bonds
Economic influences in the equity market
Supply
relative attractiveness of debt and equity financing
riights issues, buy-backs, privitisations
Demand
expectations of real economic growth
expectations of real interest rates and inflation
expectations of the equity risk premium
the exchange rate, which affects overseas demand
institutional cashflow, liabilities and investment policy
returns on alternative investments
other economic factors (e.g. tax, political climate)
Impact of inflation on equity prices
Equity markets should be relatively indifferent to inflation. This is because, if inflation is high, dividend growth would be expected to increase but so would the investor's required return (or discount rate used to discount the dividends).
Indirect effects of inflation
High inflation is often associated with high interest rates, which can be unfavourable for economic growth, which would reduce equity prices
Expectations of high inflation may cause the government to raise real interest rates (to control inflation), which would reduce equity prices
High inflation may cause greater uncertainty over inflation. This may encourage investors to increase their demand for real assets such as equities, which would increase equity prices.
Economic influences and the property market
occupation market
Expectations of real economic growth, buoyancy of trading conditions and employment levels (but the effects of this vary by property sector)
Expectations of real interest rates
Structural changes (e.g. a move to out-of-town working)
development cycles
investment market
relies to a significant extent on the occupancy market
other factors
inflation (rents should increase broadly in line with inflation, although infrequent rent reviews could lead to inflation eroding rental value
real interest rates (as these should lead to a lower valuation of future rents)
institutional cashflow, liabilties and investment policy
demand from public/ private property companies
the exchange rate, which affects overseas demand
results on alternative investments
other economic factors (e.g. tax, political climate)