Episode 2 - How do economic data and interest rates affect your investments?
Have you seen these key words in financial news headlines?
We often come across financial news headlines using terms like “GDP”, “inflation”, and “interest rates”. What do these terms mean and how do they affect investments like stocks and bonds?
Economic indicators
- We often hear about Gross Domestic Product (GDP) or GDP growth. GDP is the absolute size of the economy, while GDP growth tracks the expansion of the economy.
- Because stronger economic growth tends to translate into higher corporate profits and investor risk appetite, very often it is positively correlated with equity market performance.
- Stronger GDP growth tends to support a “risk on” environment, which makes lower-risk assets such as bonds less attractive on a relative basis.
Source: Bloomberg, as of June 30, 2024.
- The Purchasing Managers' Index (PMI) is a leading indicator of economic conditions. Investors tend to use PMI to gauge the direction of GDP.
- For long-term investors, the expectation of future GDP growth can play an important role in formulating investment strategies.
Source: National Bureau of Statistics of China, as of July 31, 2024.
Inflation
- Inflation is measured by consumer price index (CPI).
- Headline inflation is defined as the change in the prices of a basket of goods and services that are typically purchased by households.
- Apart from headline inflation, investors also pay attention to core CPI.
Effect of inflation on fixed income investments
- Inflation can significantly reduce real returns, especially on fixed income investments.
- This is because the purchasing power of the constant interest payments declines as inflation rises.
- As a result, prices on current bonds tend to fall when inflation is increasing.
Case study: Consider a one-year bond with a $1,000 face value.
- An investor purchases the one-year bond for $1,000 with 5% nominal interest rate (or “coupon rate”).
- Over the next 12 months, the investor will receive interest payments based on a 5% nominal annualized interest rate (about $4.16 per month in interest) – when the bond matures and the principle is repaid, the investor will have received $1,050.
- But over the past year, the value of each dollar has decreased due to inflation. Assuming a 3% inflation rate, the investor’s real rate of return on this bond is 2% rather than 5%. This means the real value of the returned principal investment is just $970.
Effect of inflation on equities
- Theoretically, a company’s revenues and earnings should increase at a similar pace as inflation. This means the price of the equities should rise along with inflation.
- Similar to fixed income investments, high inflation can negatively impact nominal returns. For example, assume your equity portfolio delivers a return of 5%, if inflation is at 6%, the real return is negative.
Effect of inflation on real assets
- Real assets, such as commodities and real estate, tend to have a positive relationship with inflation.
- Inflation is measured by tracking the price of goods and services which often contain commodities (such as oil and metal). Historically, commodity prices tend to go up when inflation is rising.
- When it comes to real estate, property owners often increase rent payments in line with the CPI, which can translate to income and investor distributions.
Interest rates
Why do central banks hike or cut interest rates?
- Central banks use interest rates, or “monetary policy”, as a tool for managing the economy. The Federal Reserve (“The Fed”) is the central bank of the United States.
- The Fed’s modern statutory mandate, as described in the 1977 amendment to the Federal Reserve Act, is to promote maximum employment and stable prices.*
- These goals are commonly referred to as the “dual mandate”.
*Source: The Federal Reserve, March 25, 2024
- Interest rates have a direct impact on the cost of borrowing and the return on savings.
- While central banks seek low inflation, they also want to avoid inflation that falls below target, typically around 2%. Without the expectation of certain inflation levels, companies will avoid making long-term investments.
- On the other hand, if inflation becomes uncomfortably high, like what the US economy experienced starting around 2022, the Fed can raise rates (i.e. the cost of borrowing), which could slow the economy.
Source: Bloomberg, as of July 31, 2024.
- If inflation is too low, central banks tend to set low interest rate to encourage people to borrow more and spend more and rejuvenate the economy. This has been the case in Japan, where the Bank of Japan maintained low interest rates in an effort to bring inflation up to target.
Source: Bloomberg, as of August 9, 2024.
The impact of interest rates on financial assets
- When interest rates fall: Most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, driving up demand. The bond price is likely to go up.
- When interest rates rise: Conversely, if interest rates rise, the fixed interest rate paid by a bond would appear less attractive. The bond price is likely to decline.
- Market expectation on interest rates: Even before the actual rate hike / cut happens, market expectation could move the bond markets. If the market expects interest rates to rise, bond price will fall and vice versa.
For illustrative purpose only.
The role of central banks
- Central banks use monetary policies to manage economic fluctuations and achieve price stability.
- They have different tools to help achieve these goals.
Policy Tool – Interest rates
- When central banks lower interest rates, monetary policy is easing. When they raise interest rates, monetary policy is tightening.
- Central bank announced their rate decisions regularly, normally followed by a press conference. Investors also gauge the banks’ policy stance (dovish or hawkish) through wording of the rate announcement and the tone of press conference.
Policy Tool – Quantitative Easing / Tightening
- Quantitative easing (QE) involves central bank purchasing securities in the open market to reduce interest rates and increase the money supply. QE provides banks with more liquidity and encouraging lending and investment.
- Quantitative tightening (QT) is the opposite of QE. QT could be done by either selling government bonds or letting them mature and removing them from the central bank’s cash balances.
Policy Tool – Banks’ reserve requirement ratio (RRR)
In China, the RRR determines the amount of cash banks have to keep in reserve. If the People's Bank of China lowers RRR, it frees up liquidity, so that banks can extend loans to customers and buy more bonds to support economic growth.
Why is good news sometimes bad news?
- There are cases that – stock market fell following a good GDP print. Why?
- Reason: While a hot economy and resilient consumers are encouraging for business, good news may be bad news for financial markets.
- Rapid economic growth could discourage officials at the central bank from cutting interest rates.
- This means that both corporations and households could continue to brace for high borrowing cost, which could post a threat to future business activities and personal lending, leading to uncertainties on corporate earnings.
Main data points to watch for
| Data Points | |
|---|---|
| GDP | GDP tracks the size of the economy. |
| PMI | PMI is a leading indicator of economic conditions. |
| CPI | CPI is the change in the prices of a basket of goods and services that are typically purchased by households. |
| Retail Sales | Retail sales tracks consumer demand for finished goods by measuring the purchases of durable and non-durable goods. |
| Consumer Confidence | Consumer confidence is a leading indicator of future households’ consumption. |
| Industrial Production | Industrial production is a measure of output of industrial sectors, including manufacturing, mining and utilities. |
| Exports | Exports are goods and services that are produced in one country and sold to buyers in another. |
GDP is as the sum of four factors: consumer spending, government spending, net exports, and total investment.
PMI is an indicator which measures activity in manufacturing. A reading above 50 represents an expansion when compared with the previous month, while a PMI reading under 50 represents a contraction.
“Leading indicators” are datapoints released by governments and trusted institutions that give quantitative measurement of the current and future economic, business, or investment trends.
Core inflation or Core CPI is the change in the costs of goods and services but excludes food and energy prices, as prices in these segments can fluctuate widely.
Real return is what is earned on an investment after accounting for taxes and inflation.
Nominal interest rate is the interest rate before taking inflation into account. “Real” or “effective” interest rates account for inflation.
A hawkish policy stance favours hiking interest rates aggressively. Contrary to hawkish is a dovish stance in which a central bank may lower interest rates or may go slow in raising interest rates.
Liquidity refers to the fact of being available in the form of money, rather than investments or property, or being able to be changed into money easily.
