Understanding the Influence of the Economic Environment

The valuation of assets (be they equities, bonds, property or even cash) is highly susceptible to the local and global economic environment. As such, when reviewing the performance and future prospects of a particular asset class in any economic region, there is a wide range of economic factors which should influence investors' perceptions. Below we highlight the key macroeconomic issues which investors should consider when contemplating investing in a particular region.

Fiscal Policy

Relates to the use of the government budget to provide public goods and services, to redistribute income and to affect the level of economic activity. Taxation and government expenditure are the tools used to achieve fiscal policy objectives. Financial markets prefer governments to pursue 'sensible' budgetary policies. In essence, such policies can involve: maintaining tight control over day to day spending and in so doing help dampen inflation; pursuing pro-enterprise taxation policies without unduly adding to domestic demand; and achieving budgetary discipline so that taxes equal spending over the medium term. Such 'sensible' policies should create a stable economic environment which has been shown to be most beneficial to both business needs and the longer-term interests of the economy. Fiscal policy is traditionally used as a counter-cyclical tool with government spending being increased during recessions and reduced during booms. By adopting this approach, governments can help to reduce volatility in growth rates and unemployment levels. However, as the economy becomes increasingly globalised, fiscal policy loses its effectiveness as a demand management tool.

Monetary Policy

Refers to actions taken by central banks to affect monetary and financial conditions in an economy. The main tools of monetary policy management are the official interest rate and the exchange rate. In Ireland, monetary policy is now determined externally, with the European Central Bank setting official interest rates for the entire Eurozone and with the value of the Irish punt fixed to the Euro. Politicians have placed increasing emphasis on the need to achieve and maintain price stability, particularly since the inflationary excesses of the 1970s and early 1980s. This has led to greater Central Bank independence.

Inflation

Inflation, the rate of change in the level of prices, is a key macroeconomic indicator. An economy is best served by a low rate of inflation which does not distort decision-making by individuals and corporate entities. Once a high rate of inflation becomes entrenched in an economy, interest rates must be held at higher levels for longer periods than would ordinarily be the case. This has an obvious cost in terms of output, employment and profitability. As a result, pre-empting upward movements in inflation readings is a key aim of monetary policy. For the purposes of monetary policy, price stability is generally taken to mean annual inflation rates of less than 2.5%.

Interest Rates

Manipulation of interest rates is a key tool of monetary policy. When actual or expected economic developments are threatening price stability, central banks will increase interest rates in order to slow the economy down and in so doing dampen inflationary pressures. An economy is best served by price stability where interest rates are moved relatively infrequently in order to smooth the economic cycle. As a rule of thumb, monetary policy is neutral when the official interest rate is approximate to the nominal GDP growth rate (i.e. the real growth rate adjusted for inflation).

Unemployment

In the perfect economy, unemployment is stable at or near its natural rate. This is the level of joblessness where there is minimal pressure for wage increases. In the past, it had been safe to assume that the natural rate of unemployment stood above 5%. Once the rate of unemployment moved below this level, higher earnings growth would feed through to inflation and provoke an increase in interest rates from the Central Bank. However, economic reforms in some countries which have greatly increased the flexibility of the labour market and reduced the costs involved in hiring and firing, have pushed the natural rate of unemployment lower. In the UK and the US, countries at the forefront of labour market reforms, the natural rate of unemployment may now be as low as 4%.

Government Involvement

Investment flows tend to favour economies which have relatively little direct government involvement, low taxation rates and a free-market approach to economic management. Over time, such economies should outperform their peers in terms of employment, growth and profitability.

Such economic factors not only influence investment flows but also have profound implications upon specific asset classes. The following table highlights how stock markets in particular may be supported, following changes in key economic indicators.

Positive economic factors which should support stock markets over the medium term.

• A low or declining rate of inflation
  This allows interest rates to remain low.
• Low or declining interest rates
  Reduces the cost of borrowing, increases level of capital spending and enhances profitability.
• Rising corporate profits
  If profits of individual stocks are rising, the overall market earnings (which is the aggregate of individual stocks) will also rise, allowing investors to place a higher valuation on the market.
• Political stability
  Reduces uncertainty and aids investment in riskier assets.
• An "easing" monetary policy (which implies low interest rates)
  Sets the tone for bond market performances and supports equity investment.
• Increased merger and acquisitions activity
  Potentially raises efficiency in under-performing industries.