Eleventh Edition Investments An introduction Herbert B Mayo

Eleventh Edition Investments An introduction Herbert B. Mayo The Macroeconomic Environment for Investment Decisions

The Economic Environment The economy does have periods of expansion, stagnation and contraction known as business cycle does not follow regular, predictable patterns Each of these periods would differ according to the length and severity Circumstances that affect the economy in one period may cease to exist or have marginal impact during subsequent periods Oil embargo in 1970 s Failure of commercial banks in 1930 s Credit and banking crisis in 2008

Measures of Economic Activity Gross Domestic Product (GDP): Total value of all final goods and services produced within a country with domestic factors of production Cars produced by Toyota in USA are included in USA GDP Gross National Product (GDP): Total value of all final goods and services newly produced by an economy and includes income generated abroad Income generated abroad by US firms are added while income generated in US by foreign firms are subtracted

GDP can be computed by Adding expenditures of the sectors of an economy or Adding all sources of income GDP is the summation of expenditures: GDP = C + I + G + E C = Personal consumption I = Gross private domestic investment G = Government spending E = Net exports

Importance of Fiscal and Monetary Policy Specific fiscal and monetary policies could impact the firms’ and individuals’ ability to or incentive to spend Government taxation reduces the ability of individuals/firms to spend while tax revenues spent contributes towards the GDP Lower interest rates, excessive credit encourage spending and investments Changes in consumer/business spending have immediate impact on aggregate level of output

Recession – Economic contraction that lasts for more than two quarters Length of recessions could vary from months to almost a year and half

Economic Indicators Leading indicators – Indicators that signals the direction of the economy in advance Lagging indicators - Indicators that moves behind economy Coincident indicators - Indicators that moves with the direction of the economy The time lapse between the initial decline/increase in the indicators and subsequent recession/boom could vary Practically it is difficult to say when an indicator has changed Peaks and bottoms are generally determined after the fact

Economic Indicators Index may give wrong signals Usefulness of leading indicators for stock market investments is limited as the market itself is a leading indicator Consistent with the semi strong form efficient market hypothesis

Consumer Confidence Consumer confidence affect spending Impacts corporate profits and level of employment Increase in consumer confidence will increase consumer spending and vice versa A leading indicator No formal measures in Sri Lanka

Consumer Confidence Focus on Consumer perception on business conditions Consumer perception on financial conditions Consumer willingness to purchase durables Changes in consumer confidence could lead to shift in the investment portfolio Example – Reduction in consumer confidence that leads to economic contraction Move out of growth stocks to defensive stocks such as utilities, healthcare, large firms and debt securities

Measures of Inflation – General rise in prices Prices indices measure aggregate prices Changes in an index measures inflation Inflation is measures by an index Two common indices Colombo Consumer Price Index (CCPI) Wholesale Price Index (WPI Caution Impact of inflation could vary depending on the individual Prices changes are not uniform across the country

Deflation is general decline in prices The real purchasing power of assets and income rises with deflation Deflation is rare as prices in general tend to be sticky Deflation could lead to economic stagnation

The Role of the Central Bank The Central Bank of Sri Lanka Responsible for the monitory policy Purpose of the Central Bank : To control the money supply in order to achieve: Maintain economic and price stability Maintain financial system stability

Monitory Policy refers to changes in the money supply and credit Expansionary (Easy) MP : Increase in money supply and credit to help expand the level of income and employment Contractionary (Tight) MP : Reduction in money supply to help fight inflation

Interest Rates Impact of CB’s MP is felt through its effect on interest rates Affected by the actions of the CB to increase or decrease liquidity in the banking system Depend on the demand for and supply of loanable funds Lower interest rates would help spur the economic activities by encouraging investments Higher interest rates will slow down economic activities In response to fight inflation or address a situation of “overheat” scenario

A Specific Interest Rate The current nominal interest rate is the sum of real risk free rate plus a series of risk premiums: Expected inflation Possibility of default ▪ Indicated by credit ratings Liquidity ▪ Ease with which an asset is converted to cash without loosing its value ▪ Depend on the depth of the market for the security and issue size (larger issues will have higher liquidity) Term to maturity ▪ Investors prefer short term bonds ▪ Longer maturity bond prices are more sensitive to interest rate changes Actual nominal interest rate is an interplay of all above factors Anomalies in bond yield possible

Impact of The Central Bank CB affects interest rates through its impact on the ability of the banking and financial systems to create credit. To control inflation or To stimulate employment and economic growth Monitory Policy tools used by the CB Reserve requirement of banks Policy rates Open market operations

The Reserve Requirement The percentage of cash that a bank must hold against its deposit liabilities Required Reserve : - Reserves that must be kept against deposit liabilities Excess Reserve : - Amount of reserves available for lending Changes to reserve requirement affects the lending capacity of banks Supply for money and credit expands when excess reserves are lent by banks

The Policy Rates The interest rate, the CB charges/pays banks for borrowing/lending reserves Repurchase rate Reverse repurchase rate By borrowing reserves, a bank increase its excess reserves that would in turn increase money and credit supply Changing the rate, the CB charges banks to borrow reserves

The Inter Bank Rate The rate of interest a bank charges from another bank for borrowing reserves Banks with excess liquidity can lend such liquidity to banks with shortfall in liquidity at the Inter Bank Rate Not set by the CB Determined via demand supply

Open Market Operations The buying and selling of Treasury Securities by the CB Expansionary MP CB purchases securities thereby increasing money supply (as reserves are increased) Contractionary MP CB sells securities thereby reducing money supply (as reserves are decreased) Changes in government securities rates are transferred to other interest rates as well Short term government securities are considered as the safest of all debt instruments and hence considered as the risk free rate Open market operations have direct and immediate impact on the money supply By far the most important and effective tool of monetary policy

Impact on Stock Prices A change in interest rates is transferred to stock prices through its Impact on the required rate of return ▪ Used to discount future cash flows Impact on earnings Higher interest rates Will adversely affect stock prices Lower interest rates Will positively affect stock price

Monitory Policy Statement Investors watch the CB with the hope of anticipating the next change in MP Meetings of the Monetary Board Monetary Policy Statements Scrutinized for clues to future actions of the Monetary Board Market anticipates changes in MP Do not react to anticipated changes in MP However, market will react to unanticipated changes in MP

Money Supply Narrow Money - The sum of currency held by the public and demand deposits held by the public with commercial banks Broad Money – The sum of currency held by the public and all deposits held by the public with commercial banks Reserve Money (Base Money) - Currency issued by CB and commercial banks' deposits with the Central Bank Analysts track the changes in money supply in an effort to perceive changes in monitory policy

Money Supply CB systematically increases the money supply overtime to maintain the economic growth If money supply grows to slow Economic growth will be constrained which would reduce stock prices If money supply grows to fast Inflation may result which is associated with higher interest rate and lower stock prices Challenge is to determine the rate of growth in money supply that would create sustained economic growth over time without creating stagnation or inflation

Fiscal Policy Taxation, expenditure and debt management by the Government Fiscal Policy may be used to pursue the economic goals of price stability, full employment and economic growth

Taxation Increase in corporate taxes reduces earnings, dividends and retaining earnings for growth driving the stock prices down Increase in personal income taxes reduces disposal income that would reduce personal consumption, savings adverse impacting the stock prices Certain taxes could impact specific securities (example : Tax exempt bonds) Certain assets and investments may have favorable tax treatments

Expenditure Government spending could affect security prices Can increase the earnings of firms Government spending could have two scenarios Deficit spending Surplus

Deficit Spending Government expenditures exceeding government revenues Sources of funds to finance the deficit: Commercial banks General public Central Bank Foreign borrowings Sale of securities to the general public or banks These securities compete directly for funds driving up the interest rate Banks would ration the supply of loanable funds Higher borrowing costs would adversely ▪ impact corporate earnings ▪ make margin loans unattractive driving down the demand for securities Can increase the rate for deposit products of banks

Deficit Spending Borrowing from CB : - Same impact as if CB had purchased securities through the open market operation Would increase the money supply When CB buys the securities issued to finance the government’s deficit CB is monetizing the debt because the new money is created

Surplus Government revenues exceed government expenditure Question of how to use any surplus