Investment Market influences are economic

Investment market influences are many and varied: economics is one of the most basic of the fundamentals that influence investment markets – and the focus of this article. But emotion, sentiment, ‘information’ and bias also have their effect (and they are mentioned in other posts in this website).

Central Banks and Monetary Policy

investment market influences - Reserve Bank of Australia buildingAs most investors will be aware, Central Banks, such as the Reserve Bank of Australia, play an important role in managing their economies as they exercise their influence over monetary policy.

Monetary policy relates basically to interest rates and the supply of money, i.e. notes, in the system. Central Banks have the ability to control this simply by printing or withdrawing notes to ensure that the amount of cash available is appropriate.

Central Banks are constantly reviewing and ‘tweaking’ monetary policy. When all is going well and the aim is merely to maintain the status quo, policy settings are said to be neutral i.e. interest rates and the supply of money are left unchanged. Central Banks will act to cool an overheated economy and control inflation by tightening policy settings i.e raising interest rates and taking cash out of the system. On the other hand Central Banks will seek to stimulate a slowing economy by cutting interest rates and printing more money, or in other words, by loosening policy settings.

When we first posted this article, economies around the world were slowing – and the latter of the above scenarios was in full effect. The other financial impact on markets is fiscal policy.

Governments are responsible for fiscal policy (and its impact on the economy)

The role of government is to use taxation and centralised spending policies/ programs to investment market influences - federal governments either stimulate or to  moderate the rate of growth of the economy. If the programs adopted by government impact the productivity of the private sector, the economy will respond accordingly (reducing productivity will cause economic slowdown; increasing it will lead to growth). Governments achieve their fiscal policy through implementation of the measures passed through the parliament from the annual budget.

Investor attitudes and asset allocation

The implication of this going forward, which many investors fail to realise, is that if they continue to hold cash as opposed to assets like shares and property then they will have a real problem. The reasons for this problem are twofold:

  • Firstly, at present1, interest rates are low – in fact the return on cash has dropped by around 50% (halved) over less than 12 months. That situation is unlikely to change until the economy recovers significantly;
  • Secondly, governments around the world have been printing money to recapitalise the financial system. This may ultimately be inflationary as the more notes there are in circulation the weaker the currency is perceived to be, and therefore the more cash sellers will demand for their goods and services. (In other words, you can’t fight inflation with cash – you can only fight it with assets – because you can demand more cash for them. You can’t demand more cash for cash! You can of course exercise more monetary discipline and withdraw some of the liquidity – at an appropriate time in the cycle.)

So now (2017) we have the following scenario:

– Cash yields are approaching all time lows; and
– Asset valuations are hovering around all time highs.

Investment Returns anticipation

If we consider a typical diversified balanced to growth portfolio: historically, long term returns in the range of 8% – 10% have consisted of approximately 4% yield and approximately 4% – 6% capital growth. At present we are seeing a situation of yields from dividends and rental income etc. approaching 10%, zero capital growth and asset values which have fallen on average around 50%. Considering the well understood inverse relationship between ongoing yields and asset values and the tendency of markets to revert to their mean over time, for yields to return to their normal 4% – 5% range i.e halve from their current levels, necessarily asset values must double i.e. increase by 100%. Although the timing of this recovery unfortunately is impossible to predict we know from previous cycles that markets will inevitably recover.

We can however identify at least three factors that will assist in raising the price of growth assets:

  • Firstly, when cash holders realise that their real return has fallen to zero or negative;
  • Secondly, when cash holders come to the realisation that the vast majority of major companies are still making profits and paying attractive dividends; that dividends represent only a portion of profits; and that commercial properties are still well tenanted and generating solid rental incomes – consequently re-entering the market; and
  • Thirdly, when the weak players in the market have finally been taken over by their stronger competitors.

All of these factors will eventually lead cash holders to seek the attractive yields currently available on growth assets thereby driving prices up and yields down to their long term sustainable norms. The missing factor at present is ‘confidence’, as uncertainty continues to drive investor sentiment. However sentiment is merely a short term driver of investment markets. In the long term we know that markets are driven by fundamentals, the most basic of which is that active business assets will generate a higher return than passively held cash.

In summary, if you hold assets1 you are in a much better position than if you are holding cash. Further, given the severity of the downturn, it would be reasonable to expect an extended period of stability after the recent excesses have finally been purged from the system.

As part of the update to this article we draw the readers attention to articles on the various risks associated with the various 1investment asset classes ; as well as to another recently updated and re-posted article warning against the over-regulation of investment risk, which risk is so critical to investment returns. These include –

The experienced advisers at Continuum Financial Planners Pty Ltd are ready to show you the benefits of working with our policy – ‘we listen, we understand; and we have solutions’ – and to help you establish a strategic long-term plan to achieve your financial goals within your risk aversion and time constraints. Please call us on 07-34213456; or use the online facility to Contact Us to arrange a meeting at a mutually convenient time and place.

[This article was originally posted in March 2009: it has been refreshed/ updated occasionally, most recently in June 2017.]