Economics and Investment Markets

In this reading, we have sought to explain the fundamental connection between the prices of financial assets and the underlying economy. The connection should be strong because ultimately all financial assets represent a claim on the real economy. Because all financial assets offer a means of deferring consumption, to make the connection tangible we have explored the relationship between these asset prices and the consumption and saving decisions of economic agents.

• At any point in time, the market value of any financial security is simply the sum of discounted values of the cash flows that the security is expected to produce. The timing and magnitude of these expected cash flows will thus be an integral part of the security’s market value, as will the discount rate applied to these expected cash flows, which is the sum of a real default-free interest rate, expected inflation, and possibly several risk premiums. Each of these elements will be influenced by the business cycle. It is through these components that the real economy exerts its influence on the market value of financial instruments.

• The average level of real short-term interest rates is positively related to the trend rate of growth of the underlying economy and also to the volatility of economic growth in the economy. Other things being equal, these relationships mean that we should expect to find that the average level of real short-term interest rates is higher in an economy with high and volatile growth and lower in an economy with lower, more stable growth.

• On average, over time, according to the Taylor rule, a central bank’s policy rate should comprise the sum of an economy’s trend growth plus inflation expectations, which might, in turn, be anchored to an explicit inflation target. This policy rate level is referred to as the neutral rate. Other things being equal, when inflation is above (below) the targeted level, the policy rate should be above (below) the neutral rate, and when the output gap is positive (negative), the policy rate should also be above (below) the neutral rate. The policy rate can thus vary over time with inflation expectations and the economy’s output gap.

• Short-term nominal rates will be closely related to a central bank’s policy rate of interest and will comprise the real interest rate that is required to balance the requirements of savers and investors plus investors’ expectations of inflation over the relevant borrowing or lending period. Short-term nominal interest rates will be positively related to short-term real interest rates and to inflation expectations.

• If bond investors were risk neutral, then the term structure of interest rates would be determined by short-term interest rate expectations. But bond investors are risk averse, which means that they will normally demand a risk premium for investing in even default-free government bonds. This risk premium will generally rise with the maturity of these bonds because longer-dated government bonds tend to be less negatively correlated with consumption and, therefore, represent a less useful consumption hedge for investors. Overall, the shape of the curve will be determined by a combination of short-term interest rates and inflation expectations as well as risk premiums. In turn, these factors will be influenced by the business cycle and policymakers.

• The yield differential between default-free conventional government bonds and index-linked equivalents will be driven by inflation expectations and a risk premium. The risk premium will be largely influenced by investors’ uncertainty about future inflation.

• The difference between the yield on a corporate bond and that on a government bond with the same currency denomination and maturity is referred to as the measured credit spread. It is conceptually akin (but not equal) to the risk premium demanded by investors in compensation for the additional credit risk that they bear compared with that embodied in the default-free government bond. It tends to rise in times of economic weakness, as the probability of default rises, and tends to narrow in times of robust economic growth, when defaults are less common.

• The uncertainty about and time variation in future equity cash flows (dividends) is a distinct feature of equity investment, as opposed to corporate bond investment. This feature explains why we would expect the equity premium to be larger than the credit premium. In times of economic weakness or stress, the uncertainty about future dividends will tend to be higher, and we should thus expect the equity risk premium to rise in such an economic environment.

• Given the uncertain nature of the cash flows generated by equities, investors will demand an equity risk premium because the consumption hedging properties of equities are poor. In other words, equities tend not to pay off in bad times. Because in the event of company failure an equity holder will lose all of his or her investment whereas an investor in the company’s bonds may recover a significant portion of his or her investment, it would be reasonable to assume that a risk-averse investor would demand a higher premium on an equity holding than on a corporate bond holding. The two premiums will tend to be positively correlated over time and will tend to be influenced by the business cycle in similar ways.

• The P/E tends to rise during periods of economic expansion and to fall during recessions. A “high” P/E could be the result of a number of factors, including the following: falling real interest rates, a decline in the equity risk premium, an increase in the expectation of future real earnings growth, an expectation of lower operating and/or financial risk, or a combination of all of these factors. All of these components will be influenced by the business cycle.

• The market value of an investment in commercial property can be derived in much the same way as the market value of an investment in equity. The cash flows come in the form of rent, which can be enhanced with additional redevelopment values as leases on properties expire. These cash flows are uncertain, and the uncertainty surrounding them will tend to rise when the economy turns down. We might thus expect the risk premium demanded on commercial property investments to rise in these times.

• The pro-cyclical nature of commercial property prices means that investors will generally demand a relatively high risk premium in return for investing in this asset class. The reason is that commercial property is not a very good hedge against bad economic outcomes. In addition, the illiquid nature of property investment means that investors may also demand a liquidity premium for investing in this asset class.