Introduction to Financial Markets PDF

The South African Institute of Financial Markets Introduction to Financial Markets © Ingrid Goodspeed: October 2016 Preface The Registered Person Examination (RPE) has been designed as an entry-level qualification for the South African financial markets. Details can be found at www.saifm.co.za/rpe.htm. The qualification has eight modules: The Regulation and Ethics of the South African Financial Markets (compulsory module) Introduction to the Financial Markets (compulsory module) The Equity Market (elective module) The Bond Market (elective module) The Derivatives Market (elective module) The South African Money Market (elective module) The South African Foreign Exchange Market (elective module) Agricultural Products Market Dealers Examination (elective module) The objective of this module is to provide the student with the necessary information to understand the financial markets in South Africa and internationally and to prepare the student for the South African Institute of Financial Market’s Introduction to Financial Markets examination. The guide is structured as follows: chapter 1 outlines the financial system of which financial markets are an integral part. Chapter 2 discusses the macro-economic environment in which financial markets function. Chapters 3 and 4 introduce the quantitative aspects of financial markets – respectively, the time value of money and statistics. Chapters 5, 6, 7, 8, 9 and 10 focus on the features, instruments, and participants of the foreign exchange, money, bond, equity, derivatives and commodities markets respectively. Chapter 11 outlines savings and investment instruments. Portfolio management - the process of putting together and maintaining the proper set of assets (such as those discussed in chapter 5 to 10) to meet the objectives of the investor - is considered in chapters 12 and 13. Students are encouraged to keep up to date with local and international financial market developments. The following internet sites may prove useful: 2 JSE Ltd www.jse.co.za Financial Services Board www.fsb.co.za South Africa National Treasury www.treasury.gov.za Strate Ltd www.strate.co.za South African Reserve Bank www.reservebank.co.za Bank for International Settlements www.bis.org Financial Stability Board www.fsb.org International Monetary Fund www.imf.org International Organisation of Securities Commissions www.iosco.org International World Bank www.worldbank.org New York Stock Exchange www.nyse.com London Stock Exchange www.londonstockexchange.com NYSE Euronext (including LIFFE) www.euronext.com World Federation of Exchanges www.world-exchanges.org 3 Table of contents 1 The financial system......................................................................................................... 8 2 The economy.................................................................................................................. 30 3 Time value of money...................................................................................................... 58 4 Introduction to statistical concepts................................................................................ 73 5 The foreign exchange market......................................................................................... 94 6 The money market....................................................................................................... 102 7 The bond and long-term debt market.......................................................................... 113 8 The equity market........................................................................................................ 123 9 The derivatives market................................................................................................. 137 10 The commodities market............................................................................................. 158 11 Investment instruments............................................................................................... 168 12 Introduction to portfolio theory................................................................................... 184 13 Portfolio Management................................................................................................. 218 Glossary.................................................................................................................................. 229 Bibliography........................................................................................................................... 234 Appendix A: Formula sheet Introduction to the financial markets....................................... 236 4 Detailed table of contents 1 The financial system......................................................................................................... 8 The financial system defined........................................................................................................ 8 The flow of funds and financial intermediation........................................................................... 9 Functions of the financial system............................................................................................... 21 Financial market rates................................................................................................................ 23 Determining financial market prices.......................................................................................... 25 2 The economy.................................................................................................................. 30 Economic systems....................................................................................................................... 30 The flows of economic activity................................................................................................... 32 Economic objectives................................................................................................................... 35 Economic policy.......................................................................................................................... 35 Business cycle............................................................................................................................. 38 Economic indicators.................................................................................................................... 43 Globalisation of financial markets.............................................................................................. 54 3 Time value of money...................................................................................................... 58 Introduction................................................................................................................................ 58 The yield curve............................................................................................................................ 60 Interest rate calculations............................................................................................................ 62 Present and future value of an annuity...................................................................................... 67 Present and future values of unequal cash flows....................................................................... 68 Net present value....................................................................................................................... 69 Internal rate of return................................................................................................................. 70 4 Introduction to statistical concepts................................................................................ 73 Introduction................................................................................................................................ 73 Descriptive statistics................................................................................................................... 74 Inferential statistics.................................................................................................................... 85 5 The foreign exchange market......................................................................................... 94 The market defined.................................................................................................................... 94 Characteristics of the market..................................................................................................... 95 Foreign exchange market instruments....................................................................................... 96 Foreign exchange market participants....................................................................................... 98 5 6 The money market....................................................................................................... 102 The market defined.................................................................................................................. 102 Characteristics of the market................................................................................................... 102 Money market instruments...................................................................................................... 103 Money market participants...................................................................................................... 109 7 The bond and long-term debt market.......................................................................... 113 The market defined.................................................................................................................. 113 Characteristics of the market................................................................................................... 113 Bond and long-term debt instruments..................................................................................... 114 Bond and long-term debt market participants......................................................................... 119 8 The equity market........................................................................................................ 123 The market defined.................................................................................................................. 123 Characteristics of the market................................................................................................... 124 Equity market instruments....................................................................................................... 129 Equity market participants....................................................................................................... 133 9 The derivatives market................................................................................................. 137 The market defined.................................................................................................................. 137 Characteristics of the market................................................................................................... 138 Derivative instruments............................................................................................................. 139 Participants in the derivatives market...................................................................................... 152 10 The commodities market............................................................................................. 158 The market defined.................................................................................................................. 158 Characteristics of the market................................................................................................... 159 Commodity market instruments.............................................................................................. 160 Participants in the commodity market..................................................................................... 163 11 Investment instruments............................................................................................... 168 Introduction.............................................................................................................................. 168 Cash.......................................................................................................................................... 168 Deposits.................................................................................................................................... 168 Equities..................................................................................................................................... 170 Bonds and long-term debt instruments................................................................................... 170 Retail savings bonds................................................................................................................. 170 Money market instruments...................................................................................................... 170 Commodities............................................................................................................................. 170 6 Products made available by long-term insurance companies.................................................. 171 Annuities................................................................................................................................... 171 Retirement funds...................................................................................................................... 173 Collective investment schemes................................................................................................ 174 Hedge funds.............................................................................................................................. 176 Property.................................................................................................................................... 177 Private equity............................................................................................................................ 180 Collectibles................................................................................................................................ 181 12 Introduction to portfolio theory................................................................................... 184 Introduction.............................................................................................................................. 184 Markowitz portfolio theory...................................................................................................... 185 Sharpe’s index models.............................................................................................................. 198 Multi-factor models.................................................................................................................. 210 Arbitrage pricing theory........................................................................................................... 213 13 Portfolio Management................................................................................................. 218 The portfolio management process defined............................................................................ 218 The portfolio management process......................................................................................... 219 Case Study: John Smith Trust.................................................................................................... 223 Glossary.................................................................................................................................. 229 Bibliography........................................................................................................................... 234 Appendix A: Formula sheet Introduction to the financial markets....................................... 236 7 1 The financial system This chapter provides a conceptual framework for understanding how the financial system works. Firstly the financial system is defined. Then the elements of the financial systems within the context of the flow of funds are discussed. Thereafter the central role that financial markets and intermediaries play in the financial system is considered. Finally the chapter describes how financial market prices are determined. Learning Outcome Statements After studying this chapter, a learner should be able to:  define the financial system and understand the roles, functions and interrelationship of its elements  understand financial intermediation, financial instruments and the flow of funds in the financial system  know the structure and mechanics of the financial markets and its participants  name the characteristics of an efficient financial market  describe the types of financial markets: spot and forward, primary and secondary, exchanges and over-the counter and interbank markets  name the functions of the financial system  understand the various measures of risk and return  define fundamental and technical analysis and their usefulness within the context of the efficient market hypothesis. The financial system defined The financial system comprises the financial markets, financial intermediaries and other financial institutions that execute the financial decisions of households, firms/businesses and governments. The financial system performs the essential economic function of channelling funds from those with a surplus of funds (i.e., net savers who spend less than their income) to those who wish to borrow (i.e., net spenders who wish to spend more than their income). Thus the financial system acts as an intermediary between surplus and deficit economic units. As such the financial system plays an important role in the allocation of funds to their most efficient use amongst competing demands. In a market system such as the South African financial system, this allocation of funds is achieved 8 through the price mechanism with prices being set by the forces of supply and demand within the various financial markets. The scope of the financial system is global. Extensive international telecommunication networks link financial markets and intermediaries so that the trading of securities and transfer of payments can take place 24 hours a day. If a company in South Africa wishes to finance a major investment, it can issue shares and list them on the New York or London stock exchanges or borrow funds from a European or Japanese pension fund. If it chooses to borrow the funds, the loan could be denominated in Euro, Yen, US Dollars or South African Rand. The flow of funds and financial intermediation Flow of funds reflects the movement of funds from those sectors that are sources of funds or capital, through intermediaries (such as banks, collective investment schemes, and pension funds), to sectors that use the funds or capital to acquire physical or financial assets. The financial system has four elements: lenders and borrowers; financial institutions; financial instruments and financial markets. The interaction between these is shown in figure 1.1. 1.2.1 Lenders and borrowers Lenders are the ultimate providers of savings while borrowers are the ultimate users of those savings. Both are non-financial entities and are referred to as surplus and deficit economic units respectively. Lenders can be referred to as investors in that they expend cash on the acquisition of financial assets such as bonds and shares and real or tangible assets such as land, buildings, gold, and paintings. Lenders and borrowers can be categorised into four sectors: household, business or corporate, government, and foreign. The household sector consists of individuals and families. In South Africa it also includes private charitable, religious and non-profit bodies as well as unincorporated businesses such as farmers and professional partnerships. The corporate sector comprises all non-financial firms or companies producing and distributing goods and services. The government sector consists of central and provincial governments as well as local authorities. The foreign sector encompasses all individuals and institutions situated in the rest of the world. 9 Usually the household sector is a net saver and thus a net provider of loanable or investable funds to the other three sectors. While the other three sectors are net users of funds, they also participate on an individual basis as providers of funds. For example a business with a temporary excess of funds will typically lend those funds for a brief period rather than reduce its indebtedness i.e., repay its loans. Similarly while the household sector is a net provider of funds, individual households do borrow funds to purchase homes and cars. Figure 1.1: Financial intermediation and the flow of funds The excess funds of surplus units can be transferred to deficit units either through direct financing or indirectly via financial intermediaries. Direct financing can only occur if lenders’ requirements in terms of risk, return and liquidity exactly match borrowers’ needs in terms of cost and term to maturity. Direct financing usually involves the use of a financial market broker who acts as a conduit between lenders and borrowers in return for a commission. Financial intermediaries perform indirect financing by making markets in two types of financial instruments – one for lenders and one for borrowers. To lenders they offer claims against themselves known as indirect securities, tailored to the risk, return and liquidity requirements of the 10 lenders. In turn they acquire claims on borrowers known as primary securities. Thus the surplus funds of lenders are invested with financial intermediaries that then re-invest the funds with borrowers. 1.2.2 Financial intermediaries Financial intermediaries are financial institutions that expedite the flow of funds from lenders to borrowers. Types of financial intermediaries include banks, insurance companies, pension and provident funds and collective investment schemes (also referred to as unit trusts or mutual funds). Banks accept deposits from lenders and on-lend the funds to borrowers. Insurers and pension and provident funds receive contractual savings from households and re-invest the funds mainly in shares and other securities such as bonds. In addition insurers perform the function of risk diversification i.e., they enable individuals or firms to distribute their risk amongst a large population of insured individuals or firms. Collective investment schemes pool the funds of many small investors and re-invest the funds in shares, bonds and other financial assets with each investor having a proportional claim on such assets. Collective investment schemes play a risk diversification role in that they spread the risk by investing in number of different securities. 1.2.3 Financial instruments Financial instruments or claims can be defined as promises to pay money in the future in exchange for present funds i.e., money today. They are created to satisfy the needs of financial system participants and as a result of financial innovation in the borrowing and financial intermediation processes, a wide range of financial instruments and products exists. Financial claims can be categorised as indirect or primary securities. Within these two categories, financial instruments can be marketable or non-marketable. Marketable instruments can be traded in secondary markets, while non-marketable instruments cannot. To recover their investment, holders of marketable securities can sell their securities to other investors in the secondary market. To recover their investment, holders of non-marketable financial instruments have recourse only to the issuers of the securities. 11 Non-marketable claims generally involve the household sector (also called the retail sector) while marketable claims are usually issued by the corporate and government sectors (or the wholesale sector). Examples of the different categories of financial instruments are shown in table 1.1. Table 1.1: Financial Instruments Primary securities Indirect securities Issued by ultimate borrowers Issued by financial intermediaries Marketable Non-marketable Marketable Non-marketable  Bankers  Hire-purchase and  Negotiable  Bank notes (issued acceptances/bills leasing contracts certificates of by the central  Promissory notes  Mortgage advances deposit (NCDs) bank)  Commercial paper  Overdrafts  Savings accounts  Company  Personal loans  Term or fixed debentures  Shares of non- deposits  Treasury bills listed companies  Insurance policies  Government bonds  Retirement  Shares of listed annuities companies 1.2.4 Financial markets 1.2.4.1 Definition Financial markets can be defined as the institutional arrangements, mechanisms and conventions that exist for the issuing and trading (i.e., buying and selling) of financial instruments. A financial market is not a single physical place but millions of participants, spread across the world and linked by vast telecommunications networks that brings together buyers and sellers of financial instruments and sets prices of those instruments in the process. 1.2.4.2 Characteristics of good financial markets In general, the characteristics of a good financial market are:  Provision of timely and accurate price and volume information on past securities transactions and prevailing supply and demand for securities  Provision of liquidity i.e., the degree to which a security can be quickly and cheaply turned into cash. Liquidity requires marketability, price continuity and market depth. Marketability is a security’s ability to be sold quickly. Price continuity exists when prices do not change from one transaction to another in the absence of substantial new information. Market depth is the ability 12 of the market to absorb large trade volumes without a significant impact on prices i.e., there are many potential buyers and sellers willing to trade at a price above and below the current market price  Internal efficiency i.e., transaction costs as a percentage of the value of the trade are low - even minimal  External or informational efficiency i.e., securities prices adapt quickly to new information so that current market prices are fair in that they reflect all available information on the security. 1.2.4.3 Financial market participants There are a number of participants in financial markets:  Borrowers issue securities  Lenders (or investors) buy or invest in securities  Financial intermediaries expedite the flow of funds from lenders to borrowers. As such they are issuers and buyers of securities and other debt instruments  Brokers (or agents) act as conduits between lenders and borrowers or buyers and sellers in return for a commission  Financial advisors provide investors with recommendations, guidance or proposals for the purchase of or investment in financial instruments. Financial advisors such as investment banks provide advice to corporate borrowers and / or issuers of securities  Dealers (or jobbers) buy and sell securities for their own account  Market makers stand ready to buy or sell certain securities at all times. They quote both a bid and an offer price to the market and profit from the spread between bid and offer prices as well as from changes in market prices. Market makers adjust their bid or offer prices depending upon positions that they hold and/or upon their outlook for changes in prices  Hedgers are exposed to the risk of adverse market price movements and mitigate the risk by using hedging instruments such as derivatives  Speculators try to make a profit by taking a view on the market. If their view is correct, they make profits. If their view is wrong, they make losses  Arbitrageurs attempt to make profits by exploiting inefficiencies in market prices. They simultaneously buy securities in the market where the price is relatively cheap and sell securities in the market where the price is relatively expensive; thereby making risk-less profits. These categories of financial market participants are not necessarily mutually exclusive. For example a financial intermediary such as a bank may, given the range of its business activities, be a financial advisor, market marker, dealer, broker, speculator, arbitrageur and hedger. 13 1.2.4.4 Types of financial markets Financial markets can be described amongst others as cash and derivatives markets; spot and forward markets; primary and secondary markets; financial exchanges and over-the-counter markets; and interbank markets. 1.2.4.4.1 Cash and derivatives markets Cash and derivatives markets are discussed with reference to figure 1.2. Figure 1.2: Cash and derivatives markets In the foreign exchange, money, bond and equity cash markets transactions are executed for immediate delivery and settlement. The commodities market - a market for the buying and selling of commodities i.e., physical goods such as oil, gold, wheat - is a cash market but not a financial one. There are markets for the sale of other physical goods and / or investments such as the property, art and antiques. On the other hand, the financial market as defined in 1.2.4.1 is a market for the buying and selling of financial instruments. The foreign exchange market is a global decentralized market for the trading and exchange of currencies. In terms of volume of transactions it is by far the largest financial market in the world. The money market is the marketplace for trading short-term debt instruments while the bond market deals in longer-term debt issues. The distinction between money and bond markets is mainly 14 based on maturity. Most money market instruments have maturities of less than one year while bonds are issued with terms of more than one year. Both money and bond markets instruments are interest-bearing debt instruments. Shares or equities i.e., participation in the ownership of a company1 - trade on equity markets. Together the equity and bond markets form the capital market, i.e., the market in which corporations, financial institutions and governments raise long-term funds to finance capital investments and expansion projects. Derivatives are financial instruments the values of which are derived from the values of other variables. These variables can be underlying financial instruments or commodities in the cash market. For example a currency option is linked to a particular currency pair in the foreign exchange market, a bond futures contract to a certain bond in the bond market and an agricultural future to maize or wheat in the commodities market. Derivatives can be based on almost any variable – from the price of soya to the weather in Rome. There is trading internationally and in South Africa in credit, electricity, weather and insurance derivatives. While a distinction has been drawn between foreign exchange, money, bond, equity and derivatives markets, several financial instruments straddle the division between these markets. These are called hybrid financial instruments. For example a convertible bond is a hybrid of bond and equity securities. It pays a fixed coupon with a return of the principal at maturity unless the holder chooses to convert the bond into a certain number of shares of the issuing company before maturity. 1.2.4.4.2 Spot and forward markets A spot market is a market in which financial instruments are traded for immediate delivery. Spot in this context means instantly effective. The spot market is sometimes referred to as the cash market. A forward market is a market in which contracts to buy or sell financial instruments or commodities at some future date at a specified price are bought and sold. 1 Since the 2007/2008 global financial crisis and its aftermath, the doctrine of shareholder primacy has come under increasing scrutiny and criticism. Key to the debate is the question of ownership of a corporation and whether in fact the corporation is a thing capable of being owned or whether it is a legal entity that owns itself. For a discussion of these issues see http://financialmarketsjournal.co.za/the-question-of-shareholder- primacy/ 15 1.2.4.4.3 Primary and secondary markets The primary market is the market for the original sale or new issue of securities. Issuers or borrowers in the primary market may be raising capital for new investment or they may be going public i.e., converting private capital into public capital. The secondary market is a market in which previously-issued securities are resold. The proceeds from a sale of such securities do not go to the issuer of the securities but to their seller - the previous owner. A stock exchange is a secondary market in which equities are traded. It is also a primary market where shares are issued for the first time. A secondary market can be a call market or a continuous market. A call market is a market on which individual securities trade at specific times. Buy and sell orders are accumulated for a period. Then a single price is set to satisfy the largest number of orders and all the orders are transacted at that price. The method is used in smaller markets and to establish the opening price in larger markets. A continuous market is a market in which securities trade at any time the market is open. Securities traded on a secondary market can be priced by order (or auction) and / or by quote (or dealer).  Order-driven or auction markets: In an order driven market buyers and sellers submit bid and ask prices of a particular share to a central location where the orders are matched by a broker. Prices are determined principally by the terms of orders arriving at the central marketplace, also called a central-order book. Most US securities exchanges are order-driven  Quote-driven or dealer markets: In a quote driven market individual dealers act as market makers by buying and selling shares for themselves. In this type of market investors must go to a dealer and prices are determined principally by dealers’ bid/offer quotations. NASDAQ is a quote-driven market.  Combined quote- and order-driven markets: The London Stock Exchange (LSE) has both an order- and quote-driven system -its more liquid shares are traded on its order-driven system. The Johannesburg Stock Exchange (JSE) operates an order-driven, central-order-book trading system with opening, intra-day and closing auctions. 16 1.2.4.4.4 Exchanges and over-the-counter markets Exchanges are formal marketplaces where financial instruments are bought and sold. They are governed by law and the exchanges’ rules and regulations that are designed to achieve market transparency and fair price discovery by, amongst others, requiring all transactions to be reported to the exchange and giving all market participants access to offered buy and sell prices. In over-the-counter (OTC) markets financial transactions are concluded off formal exchanges through private negotiation between buyers and sellers. An OTC market generally involves a group of dealers who provide two-way trading facilities in financial instruments and stand ready to buy at the bid price and sell at the (higher) ask or offer price hoping to profit from the difference between the two prices. In South Africa and internationally money and foreign exchange markets are OTC markets. Internationally, apart from corporate bond trading on the New York Stock Exchange, bond markets are usually OTC markets. However this is due to change as more jurisdictions, including South Africa, are moving to fully exchange-traded bond markets. In South Africa the JSE’s Interest Rate Market (the former Bond Exchange of South Africa, which became a wholly-owned subsidiary of the JSE in June 2009) regulates trading in bonds. Generally equities are exchange traded. The JSE regulates trading in South African equities. Commodities and derivatives are traded OTC and on-exchange. In South Africa, exchange-traded derivatives contracts trade on the JSE derivatives market, which trades equity derivatives, bond derivatives, interest rate derivatives, currency derivatives and commodity derivatives. The main differences between OTC and exchange-traded markets are shown in table 1.2. 17 Table 1.2: Difference between over-the-counter markets and exchanges Characteristic Over-the-counter Exchange-traded Range from highly standardised (exchange look-alike) to tailor made to the specific needs of the two Fully standardised with contract Type of contract contracting parties with respect to terms determined by the exchange underlying securities, contract size, maturity and other contract terms Credit risk - the risk The exchange clearing house assumes Each party to the contract assumes that a trading party the counterparty credit risk of all counterparty credit risk defaults trading parties Trading takes place between two Trading parties generally remain Trading trading parties bilaterally agreeing a anonymous contract Market participants make use of standard master agreements Law and the rules and regulations of Regulation of market developed by industry associations the exchange such as ISDA2 Market liquidity Lower than exchange traded markets Higher than OTC markets The major advantage of over-the-counter markets is the ability to tailor-make securities to meet the specific needs of the trading parties. The advantages of an exchange relative to an over-the-counter market are lower credit risk, anonymity of trading parties, greater market regulation and higher market liquidity. The 2007/08 financial crisis revealed flaws in the structure of OTC derivatives markets as well as excessive and opaque risk-taking through OTC derivatives, which aggravated the crisis. As a result the G-20 leaders committed to implementing measures to improve the transparency and oversight of OTC derivatives. These comprise: (i) Central clearing: clear standardised OTC derivatives contracts through central counterparties (CCPs) (also known as clearing houses) (ii) Capital requirements: subject non-centrally cleared derivatives contracts to higher capital requirements (iii) Margin requirements: impose margin requirements on non-centrally cleared derivatives 2 ISDA – the International Swaps and Derivatives Association - is a New York based trade organisation that strives to make global OTC derivatives markets safe and efficient 18 (iv) Organised platform: trade all standardised OTC derivatives contracts on exchanges or electronic trading platforms (v) Trade reporting: report OTC derivatives contracts to trade repositories to increase market transparency, and assist regulators and supervisors to assess systemic risk, supervise market participants and conduct market surveillance and enforcement with respect to OTC derivatives. The International Organisation of Securities Commissioners (IOSCO) is promoting the standardisation and harmonisation of OTC derivatives trade reporting data through the design of a global Unique Transaction Identifier and Unique Product Identifier to help improve data quality and facilitate data aggregation. Jurisdictions across the world, including South Africa, are currently implementing these five elements. Since a major share of South Africa’s OTC derivatives is cross border, implementation consistent with international best practice will be required to avoid regulatory arbitrage and ensure level playing fields. 1.2.4.4.5 Interbank markets An interbank market is a wholesale money market for the offering of deposits between banks in a range of currencies usually for periods not exceeding 12 months. Interbank markets are over-the- counter markets and can be national or international. The Bank for International Settlements and the International Monetary Fund define the international interbank market as an international money market in which banks lend either to each other, cross-border or locally, in foreign currency large amounts of money usually for periods between overnight and six months. Interbank markets play at least two roles in the financial system. Firstly interbank markets can be used by central banks to transmit the influence of monetary policy by adding or draining liquidity from the financial system more effectively. Secondly, well-functioning interbank markets effectively channel liquidity from banks with a surplus of funds to those with a liquidity deficit. Various interest rate benchmarks are used in the interbank market. These include the Johannesburg Interbank Agreed Rate (JIBAR), the London Interbank Offered Rate (LIBOR), the Euro Interbank Offered Rate (EURIBOR) and the Tokyo Interbank Offered Rate (TIBOR). These reference rates are widely used in interbank markets and the wider global financial system as benchmarks for a large number of financial products and contracts. 19 Since 2009 details of the manipulation of financial benchmarks have emerged as regulators in jurisdictions including the U.S., U.K., Canada, Japan, Switzerland and E.U. started investigating the fixing and false reporting of LIBOR, EURIBOR and TIBOR. Employees in financial institutions around the world apparently attempted to fix such benchmarks to benefit themselves or their firms. In February 2013 the G20 asked the Financial Stability Board to address the uncertainty surrounding the integrity of these reference rates by undertaking a fundamental review of them and implementing plans for reform to ensure that interest rate benchmarks are robust and appropriately used by market participants. In July 2015 the Financial Stability Board issued recommendations to reform interest-rate benchmarks. By July 2016 authorities in the European Union, United Kingdom, Japan, Australia, Canada, Hong Kong, Mexico, Singapore and South Africa, had taken steps to improve the interbank rates in their jurisdictions and ensure that such benchmark rates are robust and appropriately used by market participants. Apart from reforming existing interest rate benchmarks steps are being taken to identify alternative risk-free rates for benchmarks as there are financial transactions, including many derivative transactions, that should ideally be using reference rates that are near to risk free i.e., without bank credit risk. Thus when fully implemented, jurisdictions will have two groups of reference rates of interest: (i) a rate with bank credit risk and (ii) a (near) risk-free rate. 1.2.5 Financial market indices Financial market indices attempt to reflect the overall behaviour of a group of shares or other securities such as bonds. Examples of South African financial market indices are the FTSE/JSE All Share Index, STeFI Money Market Indices and JSE Socially Responsible Investment Index. International indices include the U.K.’s FTSE All-Share, the U.S.’s NYSE Composite and Standard & Poors 500 Index (S&P 500)., and Japan’s TOPIX. Financial market indices are used: As a benchmark to measure portfolio performance To create and track index funds. An index fund is a collective investment scheme with a portfolio constructed to match the components of an index such as the FTSE/JSE Top 40 index To estimate market rates of return To predict future share price movements in technical analysis As a proxy for the market portfolio when estimating systematic risk (see chapter 12). 20 Functions of the financial system The core functions of the financial system are:  Channelling savings into real investment  Pooling of savings  Clearing and settlement of payments  Managing risks  Providing information. 1.3.1 Channel savings into investment The financial system operates as a channel through which savings can finance real investment i.e., tangible and productive assets such as factories, plants and machinery. It channels funds from those who wish to save (surplus economic units) to those who need to borrow (deficit economic units) to such purchase or build such assets. Channelling savings can take place: Over time. The financial system provides a link between the present and the future. It allows savers to convert current income into future spending and borrowers current spending into future income. Across industries and geographical regions. Capital resources can be transferred from where they are available and under-utilised to where they can be most effectively used. For example emerging markets such as Poland, Russia, Brazil and South Africa require large amounts of capital to support growth while mature economies such as Germany, the United Kingdom and the United States tend to have surplus capital. 1.3.2 Pooling savings The financial system provides the mechanisms to pool small amounts of funds for on-lending in larger parcels to business firms thereby enabling them to make large capital investments. In addition individual households can participate in investments that require large lump sums of money by pooling their funds and then sub-dividing shares in the investment e.g. collective investment schemes. 21 1.3.3 Clearance and settlement of payments The financial system provides an efficient way to clear and settle payments thereby facilitating the exchange of goods, services and assets. Payment facilities include bank notes, cheques, debit and credit card payments and electronic funds transfers. 1.3.4 Management of risk Financial intermediaries transform unacceptable claims on borrowers to acceptable claims on themselves i.e., the risky long-term loans of borrowers are transformed into less-risky liquid assets for surplus units. This transformation process is shown in table 1.3. For example banks accept short-term deposits from lenders and transform these into long-term loans for borrowers. In this process the bank assumes liquidity risk. Banks accept relatively small amounts from several lenders and pool these to lend large amounts to borrowers. In this process the bank assumes liquidity risk and credit risk with respect to the borrowers. Lenders on the other hand are exposed to the bank’s creditworthiness. Table 1.3: Intermediation role of banks Risk assumed by Banks transform- Lenders’/investors’ assets Borrowers’ loans banks Short-term e.g. demand Maturity Long-term e.g. 5-year loan Liquidity risk deposits Small amounts e.g. savings Large amounts e.g. housing Denomination Liquidity risk accounts loan Variable rate e.g. variable- Interest rate Fixed rate e.g. fixed deposit Interest-rate risk rate loan Currency Local currency Foreign currency Exchange rate risk Investor is exposed to the The bank is exposed to the bank in respect of credit borrower in respect of Credit exposure risk i.e., to the credit risk i.e., to the Credit risk creditworthiness of the creditworthiness of the bank borrower 1.3.5 Information provision The financial system communicates information on the following: 22  Borrowers’ creditworthiness: It is costly for individual households to obtain information on a borrower’s creditworthiness. However if financial intermediaries do this on behalf of many small savers, search costs are reduced  The prices of securities and market rates: This supports firms in their selection of investment projects and financing alternatives. In addition it assists asset managers to make investment decisions and households to make savings decisions Financial market rates There are essentially three financial market rates:  Interest rates  Exchange rates  Holding period return 1.4.1 Interest rates An interest rate is the price, levied as a percentage, paid by borrowers for the use of money they do not own and received by lenders for deferring consumption or giving up liquidity. Factors affecting the supply and demand for money and hence the interest rate includes the following:  Production opportunities. Potential returns within an economy from investing in productive, cash-generating assets  Liquidity. Lenders demand compensation for loss of liquidity. A security is considered to be liquid if it can be converted into cash at short notice at a reasonable price  Time preference. Lenders require compensation for saving money for use in the future rather than spending it in the present  Risk. Lenders charge a premium if investment returns are uncertain i.e., if there is a risk that the borrower will default. The risk premium increases as the borrowers’ creditworthiness decreases. Sovereign (government) debt generally has no risk premium within a country and therefore pays a risk-free rate. A country risk premium may apply outside a country’s borders  Inflation. Lenders require a premium equal to the expected inflation rate over the life of the security 23 1.4.2 Exchange rate The exchange rate is the price at which one currency is exchanged for another currency. The actual exchange rate at any one time is determined by supply and demand conditions for the relevant currencies within the foreign exchange market. 1.4.3 Holding period return Interest rates are promised rates i.e., they are based on contractual obligation. However other assets such as property, shares, commodities and works of art do not carry promised rates of return. The return from holding these assets comes from the following two sources: Price or capital appreciation (depreciation) i.e., any gain (loss) in the market price of the asset Cash flow (if any) produced by the asset e.g., cash dividends paid to shareholders, rental income from property. Not all assets produce cash flows e.g. commodities. The holding period return (HPR) is the total return on an asset or portfolio of assets over the period it was held. Holding period return does not take into account reinvestment income between the time cash flows occur and the end of the holding period. For example assume at the beginning of the year a share is bought for R50. At the end of the year the share pays a dividend of R2.50 and is sold for a price of R55. In this case the holding period of the investment is one year. The HPR for the share is 15.0%; calculated as follows: HPR  capital gain(loss)  cashflow end price of share  beginning price of share cash dividend   beginning price of share beginning price of share 55.00  50.00 2.50   50.00 50.00  15.0% If the share price it is sold for is R45 at year end the holding period return is –5%; calculated as follows: 45.00  50.00 2.50 HPR   50.00 50.00   5.0 % 24 Assume a painting is purchased at the beginning of 2001 for R2 000. At an auction on 31 December 2009 the painting is sold for R3 000. In this case the holding period is 9 years. The art investor’s holding period return is 50.0%; calculated as follows: HPR  capital gain(loss)  cashflow 3 000  2 000  0 2 000  50.0% The 50% return represents the return over 9 years. It may be more convenient for comparative purposes to convert this to an effective annual rate as follows: EAR  1  HPR1 / n  1 where n  holding period in years EAR  1  0.50 1 / 9  1  4.6% Determining financial market prices 1.5.1 Fundamental and technical analysis The two techniques frequently used to study financial market securities and their expected prices and to make investment decisions based on such analysis are technical and fundamental analysis. Fundamental analysis estimates the intrinsic value of a company by examining its characteristics (such as from its financial statements) and environment including the economy and industry to which the company belongs. Technical analysis is not concerned about the intrinsic value of a share. Instead share price changes are predicted from the study of graphs on which prices and sometimes trading volumes are plotted. Technical analysts examine the price action of the stock market instead of the fundamental factors that may impact share prices. A number of assumptions underlie technical analysis: (i) the market value of a share is determined solely by the interaction of its demand and supply; (ii) supply and demand are driven by both rational factors such as economic variables and irrational factors such as 25 gut-feel, moods and guesses; (iii) ignoring minor fluctuations, share prices move in trends, which persist for long periods of time; and (iv) current trends change in reaction to variations in supply and demand and these trend changes can eventually be identified by the action of the market. 1.5.2 Efficient markets hypothesis In contrast to both technical and fundamental analysts, proponents of the efficient markets hypothesis (EMH) believe that share prices adjust rapidly and fully to all information as it becomes available. Therefore neither existing nor past prices are of any help in predicting the future. This highlights one of the most debated and controversial questions in finance - are the price movements of financial instruments predictable or random? According to the EMH, at any given time, financial instrument prices fully reflect all available information. The market is efficient if the reaction of market prices to new information is instantaneous and unbiased. The main outcome of this theory is that price movements are random and do not follow any patterns or trends. This means that past price movements cannot be used to predict future price movements. Rather, prices follow a random walk - an inherently unpredictable pattern. There are essentially the following three forms of the EMH: The weak form of the EMH claims all past market prices and data are fully reflected in asset prices. The implication of this is that technical analysis will not be able to consistently produce excess returns, though some forms of fundamental analysis may still provide excess returns. The semi-strong form of the EMH asserts that all publicly available information is fully reflected in asset prices. The implication of this is that neither technical nor fundamental analysis can be used to produce excess returns. The strong form of the EMH: All information, public and private is fully reflected in asset prices. The implication of this is that even insider information cannot be used to beat the market. There are a number of challenges to the EMH:  The existence of stock market anomalies, which are reliable, widely known and inexplicable patterns in asset price returns. Examples are the shares of small firms offering higher returns than those of large ones and the ‘January effect’, which shows that higher returns can be earned in the first month of the year. 26  Behavioural finance, which examines the role of human psychology underlying investors' decisions and how psychological factors impact people’s financial behaviour and asset pricing and can be used to explain phenomena such as share price over- or under-reaction to new information. Traditional finance theory like EMH holds the view that the price of a financial instrument reflects, to a lesser or greater extent, all known information. Further, that the individuals who invest in financial instruments will behave rationally and carefully weigh up risk and return before making a decision that is in their best interests. Behavioural finance believes that rather than assuming markets are efficient and people are rational, attention should be paid to “animal spirits” – a term that John Maynard Keynes used to describe people’s “spontaneous urge to action” …“falling back for our motive on whim or sentiment or chance”. According to economics professor Paul Krugman in 'The Seven Habits of Highly Defective Investors' behavioural traits that make the markets anything but efficient include: think short-term; be greedy; believe in the greater fool; run with the herd; over-generalise; be trendy; and play with other people's money. According to Krugman, he did not see investors as “a predatory pack of speculative wolves” but “an extremely dangerous flock of financial sheep”. 27 Review questions 1. Define the financial system. 2. What are the four elements of the financial system? 3. Name the categories that lenders and borrowers can be grouped into. 4. Differentiate between direct and indirect financing. 5. Describe how pension funds expedite the flow of funds from lenders to borrowers. 6. Describe how banks expedite the flow of funds from lenders to borrowers. 7. List three marketable primary securities and three non-marketable indirect securities. 8. Explain the difference between primary and secondary markets. 9. What are the core functions of the financial system? 10. What is the one-year rate of return for a share that was bought for R100 paid no dividend during the year and had a market price of R102 at the end of the year? 28 Answers 1. The financial system consists of the financial markets, financial intermediaries and other financial institutions that carry out the financial decisions of households, businesses and governments. 2. The four elements of the financial system are: Lenders and borrowers Financial institutions Financial instruments Financial markets 3. Lenders and borrowers can be categorised into the household sector, the business or corporate sector, the government sector and the foreign sector. 4. In the direct financing process, funds are raised directly by borrowers from lenders usually though a financial market broker who acts as a conduit between the lender and borrower in return for a commission. In the indirect financing process, also known as financial intermediation, funds are raised from lenders by financial intermediaries and then on lent to borrowers. 5. Pension funds expedite the flow of funds from lenders to borrowers by receiving contractual savings from households and re-investing the funds in shares and other securities such as bonds. 6. Banks expedite the flow of funds from lenders to borrowers by accepting deposits from lenders and on-lending the funds to borrowers. 7. Three marketable primary securities are treasury bills, promissory notes and debentures. Three non-marketable indirect securities are savings accounts, fixed deposits and retirement annuities. 8. The primary market is the market for the original sale or new issue of financial instruments while the secondary market is a market in which previously-issued financial instruments are resold. 9. The core functions of the financial system are to channel savings into investment, pool savings, clear and settle payments, manage risks and provide information. 10. The return is 2% p.a.; calculated as follows: end price of share  beginning price of share cash dividend HPR   beginning price of share beginning price of share 102  100 0   100 100  2% 29 2 The economy Financial markets operate in an economic environment that shapes and is shaped by their activities. The objective of this chapter is to outline the interactions between the various components of the economy and to discuss mechanisms for determining the direction of current and future economic activity and performance. Firstly alternative economic systems and their underlying principles will be described. Then the flows of income, output and expenditure in a market economy will be sketched. Thereafter the role of government in the economy will be considered. After that economic indicators and their interpretation will be specified. Finally the globalisation of financial markets i.e., the increasing integration of financial markets around the world will be discussed. Learning Outcome Statements After studying this chapter, a learner should be able to:  describe alternative economic systems  understand the flow of economic activity in a market economy  understand the economic objectives in a market economy and the tools used by authorities to reach these objectives  define the business cycle and understand the relationship between the business cycle phases and economic variables  understand the impact of the business cycle on different asset classes  understand the use, features and interpretation of economic indicators  understand globalisation of financial markets in a South African context. Economic systems Scarcity exists when the needs and wants of a society exceed the resources available to satisfy them. Given scarcity, choices must be made concerning the use and apportionment of resources i.e., what should available resources be used for - what goods and services should be produced or not be produced? The approach to resource allocation – the assignment of scarce resources to the production of goods and services - allows a distinction to be made between those economies that are centrally planned and those that operate predominantly through market forces. 30 In a centrally planned or command economy most of the key decisions on production are taken by a central planning authority, usually the state and its agencies. The state normally-  owns and/or controls resources  sets priorities in the use of the resources  determines production targets for firms, which are largely owned and/or controlled by the state  directs resources to achieve the targets  attempts to co-ordinate production to ensure consistency between output and input. In the free-market or capitalist economy firms and households interact in free markets through the price system to determine the allocation of resources to the production of goods and services. The key features of the free-market system are: resources are privately owned and the owners are free to use the resources as they wish companies, which are also in private ownership, make their own production decisions production is co-coordinated by the price system - the mechanism that sends prices up when the demand for goods and services is in excess of their supply and prices down when supply is in excess of demand. In this way the price system apportions limited supplies among consumers and signals to producers where money is to be made and consequently what they ought to be producing. In a mixed economy the state provides some goods and services such as postal services and education with privately-owned companies providing the other goods and services. The exact mix of private enterprise and public activities differs from country to country and is influenced by the political philosophy of the government concerned. Given its focus on the ownership, control and utilization of a society’s resources, the economic problem of resource allocation has a political dimension. The link between a society’s economic system and political regime is illustrated in figure 2.1. Just as economic systems can extend from free-market to centrally planned, depending on the level of state intervention in resource allocation so political systems can range from democratic to authoritarian given the degree of state involvement in decision making. Market economic systems are generally associated with democratic states e.g. United Kingdom as are centrally planned economies with authoritarian states e.g. Cuba. However some authoritarian states have or are attempting to institute capitalistic economies e.g. China. Certain democratic states have a substantial degree of government intervention either by choice or from necessity e.g. during 31 times of war or financial crises. Typically demands for political change have accompanied pressures for economic reform e.g. in Eastern Europe. Figure 2.1: Political-economic systems The flows of economic activity The major participants in an economy are households, firms, the government and the foreign sector. How these interact within an economy can be described by a circular flow diagram. In its simplest form - see figure 2.2 - the economy consists of two groups: firms and households. On the resource or real side, households provide labour to firms and firms produce goods and services and supply them to households for consumption. Corresponding to these real or resource flows are financial or cash flows: firms pay households for the use of their labour and households pay firms for the goods and services firms produce. 32 Figure 2.2: Simplified circular flow of income diagram In reality the economy is more complicated. There are leakages from the circular flow: Savings. Money is received by households but not spent on consumption of goods and services Imports. Money flows to foreign firms as households consume imported goods Taxes. Money flows to the government. At the same time as the leakages are taking place, additional forms of spending occur that represent injections into the circular flow: Investment spending. Firms use capital in the production process. Capital in this context refers to assets that are capable of generating income e.g. capital equipment, plants, and premises. Capital goods have themselves been produced. Firms borrow savings from households to invest in capital to be used in the production of more goods and services. This generates income for firms producing capital goods Exports. Firms sell their production to another country in exchange for foreign exchange. The difference between a country’s exports and imports of goods is known as the trade balance and reflects the country’s basic trading position Government spending. Governments use taxation to spend on the provision of public goods and services such as defence and education. A more complete picture of the economy is shown in figure 2.3. 33 Figure 2.3: Circular flow of income diagram While the revised model of the economy is still simplified e.g. firms also save and buy imports, it does show the following: The interactions between the various components of the economy How variations in the level of economic activity can be the result of changes in a number of variables. If households reduce the amount of goods they purchase, firms’ revenues decrease. This will impact firms’ need for resources such as labour and raw materials and reduce the taxes paid to the government. A change in the amount of taxes paid to the government will impact government spending. It will also affect the level of employment. Inherent in the circular flow of income concept is the equality of total production, income and expenditure for the economy as a whole. Production gives rise to income. Income is expended on production. The total of all expenditure within an economy is referred to as aggregate demand. The main categories of aggregate demand are the following: Consumer or household spending Government spending or public expenditure Investment spending on capital goods Exports of goods and services less expenditure on imports of goods and services. 34 Consumer spending is regarded as the most important factor in determining the level of aggregate demand. Aggregate supply is the total of all goods and services produced in an economy. Economic objectives The performance of an economy is generally judged in terms of the following economic objectives:  An acceptably high rate of non-inflationary economic growth  A high and steady level of employment of the labour force  A stable general price level i.e., the avoidance of undue inflation and deflation  A favourable and stable balance of payments and  Equitable distribution of income. In most market-based economies democratically elected governments prefer levels and patterns of aggregate demand and supply to be determined by market forces without government interference. However recognition that market forces alone cannot ensure that an economy will achieve the economic objectives has resulted in state intervention occurring to some degree in all countries. The intervention can take the form of fiscal policy, monetary policy and /or direct controls, collectively economic policy. Economic policy 2.4.1 Fiscal policy Fiscal policy is the use of government spending and taxation policies to influence the overall level of economic activity. Basic circular flow analysis indicates that reductions in taxation and/or increases in government spending will inject additional income into the economy and stimulate aggregate demand. Similarly increases in taxation and/or decreases in government spending will weaken aggregate demand. Fiscal policy is said to be loosening if tax rates are lowered or public expenditure is increased. Higher tax rates or reductions in public expenditure are referred to as the tightening of fiscal policy. In South Africa National Treasury is responsible for the execution of fiscal policy. Taxation and government spending are linked in the government’s overall fiscal or budget position. A budget surplus exists when taxation and other receipts of the government exceed its payments for goods and services and debt interest. A budget deficit arises when public-sector expenditure 35 exceeds public-sector receipts. A budget deficit is financed by borrowing. Expansionary fiscal policy is usually associated with a budget deficit and contractionary fiscal policy with a budget surplus. In South Africa the budget is presented annually to Parliament by the Minister of Finance. The budget sets out the following: The government’s spending plans for the financial year. A financial year runs from 1 April of the current year to 31 March of the following year How the government intends to finance such spending e.g. through taxes and / or loans. In his 2016 budget speech, the Minister stated that, given low economic growth, , high unemployment, significant inequality and “hurtful fractures in society” the budget was formulated to (i) reduce the budget deficit; (ii) cut government expenditure mainly by curtailing personnel spending; (iii) increase taxes; (iv) reprioritise expenditure to higher education, social grant allocations; (v) respond to the impact of the drought on farmers and (vi) enable and mobilise private sector and civil society capacity by building on the success of renewable energy initiatives such as the independent power producers programme, strengthening tourism, agriculture and agro- processing, creating opportunities for participation of developers and other partners in housing, infrastructure and commercial development and addressing challenges that impact mining investment and employment... The public or national debt is the total sum of all budget deficits less all budget surpluses over time. National debt incurs interest costs and has to be paid back. It is financed by taxpayers and can be seen as a transfer between generations. To quote Herbert Hoover: “Blessed are the young, for they shall inherit the national debt”. 2.4.2 Monetary policy Monetary policy regulates the economy by influencing the monetary variables such as:  The rate of interest. Lowering interest rates encourages (i) companies to invest in capital as the cost of borrowing falls and (ii) households to increase consumption as disposable incomes rise on the back of lower mortgage and overdraft rates. Rising interest rates will typically have the opposite effect  The money supply (notes, coins, bank deposits). If the money supply is increased, interest rates tend to fall. The most important tools of monetary policy are: 36 Reserve requirements Open-market operations Bank or discount rate policy. 2.4.2.1 Reserve requirements The central bank requires banks to hold a specified proportion of their assets as cash reserves - typically against their depositors’ funds. By changing the reserve requirement the central bank can influence the money supply and credit extension. For example, if the central bank lowers the cash reserve requirement the money supply will increase as banks extend additional credit on the back of their increased lending capacity. 2.4.2.2 Open market operations Open market operations involve the purchase and sale of government and other securities by the central bank to influence the supply of money in the economy and thereby interest rates and the volume of credit. A purchase of securities – expansionary monetary policy – injects reserves into the banking system and stimulates growth of money supply and credit extension. A sale of securities – contractionary monetary policy – does the opposite. 2.4.2.3 Bank or discount rate policy The bank or discount rate is the interest rate at which the central bank lends funds to the banking system. In South Africa this rate is called the repurchase rate (repo rate). Banks borrow from the central bank primarily to meet temporary shortfalls of reserves. By varying the interest rate on these loans, the central bank is able to affect market interest rates e.g. increasing the bank rate raises the cost of borrowing from the central bank and banks will tend to build up reserves. This will decrease the money supply and reduce credit extension. An accommodative or expansionary monetary policy reduces the bank (or repo) rate at which the central bank provides credit to the banks. Monetary policy is restrictive or contractionary when the central bank increases the bank (or repo) rate. The South African Reserve Bank (SARB) is the central bank of South Africa. Operationally the SARB influences the overall lending policies of banks and the demand for money and credit in the economy indirectly through changes in bank liquidity and interest rates in the money market. The SARB applies monetary policy in South Africa within an inflation targeting framework. An inflation targeting framework has the following four elements: 37 A monetary policy goal of price stability A numerical inflation target to make the price-stability objective operational A time horizon to attain or return to the inflation target Ongoing review as to whether the inflation target will or has been met. The SARB regards its primary goal in the South African economic system to be the achievement and maintenance of price stability. Government sets the inflation target after consultation between the Reserve Bank and the National Treasury. The current target is for CPI inflation to be within the target range of 3% to 6% on a continuous basis. Fiscal policy and monetary policy must be coordinated to prevent the results of the one type of policy from cancelling out or negating the effects of the other type of policy. To achieve this coordination requires close cooperation between the National Treasury and the SARB. 2.4.2.4 Direct controls Examples of direct controls are:  Price and income policies attempt to control inflationary pressures by restraining price and wage increases  Import controls endeavour to correct balance of payment deficits by placing restrictions such as quotas and tariffs on the importation of products into the country. Business cycle Economic expansion and development does not occur smoothly. Rather than growing steadily year after year, economies experience cycles in economic activity i.e., intervals of economic expansion followed by times of recession. These cycles are termed business cycles and are defined as recurrent but non-periodic fluctuations in the general business activity of an economy. Each cycle consisting of four phases: a lower turning point (or trough), an expansion, an upper turning point (or peak) and a contraction – see figure 2.4. The simplified sequence of events that usually sets the course of the business cycle is as follows: During the expansion phase, aggregate demand increases. Firms’ inventories are run down. Production increases at a faster rate than aggregate demand as inventories are rebuilt. Businesses employ unemployed workers who spend their income on consumer goods. This generates more demand and businesses employ more people. 38 The process continues until businesses encounter capacity constraints. If firms expect continued increasing demand they will invest in capital goods - plants, factories, machinery and equipment. Consumer demand will increase on the back of the increased demand for capital goods as firms producing capital goods employ more labour. In addition, demand for investment funds increases. Production eventually reaches a ceiling due to supply constraints and bottlenecks - the upper turning point is reached. The demand for investment funds puts upward pressure on interest rates and new investment is no longer profitable. Figure 2.4: Phases of the business cycle During the contraction phase as investment demand falls, producers of capital goods lay off workers. Increased unemployment results in decreased consumer spending – businesses producing consumer goods and services cut down on production and employment. The contraction gains momentum. The trough or lower turning point is reached when production decreases to some minimum level. At this level consumer demand is steady as workers employed by the government or in industries producing essential goods and services such as food and utilities retain their jobs. Slack demand for investment funds has resulted in a fall in interest rates making new or replacement investment profitable – at least for firms providing essentials. With steady consumer demand an increase in investment demand will begin to lift the economy again. 39 The typical behaviour of economic variables in the different phases of the business cycle is outlined in table 2.1. Table 2.1: Phases of the business cycle Lower turning point Upper turning point (recovery or early Expansion Contraction (early contraction) expansion) Tend to be more Start borrowing to liquid and less finance expansion Profits weaken Businesses Profits weaken geared with higher Profits rise rapidly further profit expectations Credit demand Relatively weak Increases strongly Weakens Weak Current account of Deficit becomes Surplus becomes Deficit or small the balance of Surplus smaller or surplus smaller or negative surplus payments becomes larger Employment Relatively low Increases High Falls slowly at first Relatively stable or Tends to weaken Stabilises or tends Exchange rate tending to be Tends to strengthen Weakens to be stronger stronger Weaker (to supply Decrease or remain Exports Increase Increase local demand) weak Restraint e.g. higher Borrowing increases Stimulation e.g. tax Fiscal policy taxes and/or lower Further restraint to finance higher concessions spending expenditure Imports Relatively low Rise sharply Remain high Decrease Inflation Relatively low Increases Increases further Decreases Interest rates Relatively low Rise Rise or remain high Decline Inventory levels Low Rise Rise or remain high Decrease Investment Low Starts to rise High Decreases Prices Relatively low Rise rapidly High Fall slowly Start to increase Increase rapidly Production and Limited by capacity Decline Production capacity Idle production sales constraints substantially is at a high level capacity is absorbed Idle capacity is rapidly absorbed; Production capacity Idle capacity Requirement to Full utilisation Utilisation falls expand production capacity Salary and wage Low Rise slowly at first High Fall slowly incomes 40 Many economic indicators also display cyclical patterns. These can lead (turn in advance of), coincide with or lag (turn after) the business cycle. Leading indicators can be used to predict economic developments. The SARB uses over 200 economic time series (indicators) to determine the turning points of the South African business cycle. Using these indicators, leading, coincident and lagging composite-business-cycle indices are produced as illustrated in figure 2.5. The indices indicate the direction of change in economic activity; not the level. Figure 2.5: South African composite business cycles The longest upward phase of the South African business cycle since 1945 lasted 99 months from September 1999 to November 2007. In December 2007, this upward phase came to an end. The ensuing downward phase lasted 21 months until August 2009. The market turbulence that began in the third quarter of 2007 with the sub-prime market meltdown in the United States, led to worldwide financial market panic in September 2008 with the bankruptcy of Wall Street investment bank, Lehman Brothers and the near collapse and subsequent bailout of insurer American International Group (AIG). Credit markets seized up and liquidity evaporated. Confidence in financial institutions crumbled. Global and domestic demand declined and South African (and world) economic growth fell steeply throughout 2008 and into 2009. 41 In response to the financial and economic crises expansionary fiscal and monetary policies have been adopted in most parts of the world. At the beginning of the upward phase towards the end of 2009, the South African economy appeared to bounce back strongly with growth peaking at 3 per cent in 2011. However since then growth and employment outcomes and forecasts have been poor and November 2013 was established as the final reference date for the upper turning point meaning the most recent upward phase was from September 2009 to November 2013 and lasted 51 months. Since December 2013 South Africa has been in a downward phase. Different asset classes tend to perform differently during the phases of the business cycle. Shares tend to perform best during both the recovery and expansion phases when economic conditions are improving and company revenues are increasing. Share prices are volatile at the upper turning point of the cycle as investors become less certain about the future. Share prices decline during the contraction phase of the cycle when economic conditions are deteriorating and corporate profits are falling. Bonds are likely to perform best during the contraction phase and lower turning point when interest rates generally decline. Bonds tend to perform less well during the late expansion phase and upper turning point when interest rates are apt to rise. Property tends to perform well during recovery and expansion when interest rates are relatively low and employment and economic conditions are improving. Property does not perform as well during the contraction phase when economic conditions are deteriorating and employment is declining. Cash is generally more attractive during the contraction phase when economic conditions are worsening and there is widespread pessimism, particularly in the business sector. Commodities are likely to perform well during the expansion phase of the business cycle when production is increasing rapidly; production capacity is at or near full utilisation and demand for commodities is high. Commodities do not perform well during contraction when manufacturers are reducing production and operating at less than full capacity. 42 Precious metals tend to perform best during the upper turning point when the demand for precious metals like gold, platinum and silver rises for industrial purposes and as a hedge against inflation. During the contraction phase, when industrial demand is low and inflation is declining, precious metals may not perform as well. Economic indicators Economic indicators provide insights into how economies and markets are performing. Their interpretation is important to various market participants and observers for a number of reasons. Economists and other market analysts use economic indicators to (i) assess the performance of an economy (ii) judge the effectiveness of a government’s economic policy (iii) compare the economic performance of different countries and (iv) form economic and market forecasts and views. Investors use economic indicators to attempt to obtain the best investment return given risk. Businesses use economic indicators to determine if the time is right to undertake new capital investment projects; takeovers or mergers; or entry into new markets. The following economic indicators will be discussed: Gross Domestic Product (GDP) Consumption expenditure by households Government spending Investment spending Consumer Price Index (CPI) Producer Price Index (PPI) Balance of payments. In each case the indicator will be defined. Then how the indicator is generally presented and what should be focused on when analysing the indicator are noted. Thereafter the timing of the indicator with respect to the business cycle as well as the interpretation of the indicator are considered. Finally the impact of the indicator on market variables is highlighted. 43 2.6.1 Gross Domestic Product (GDP) Definition: The total value of all goods and services produced in a country in a particular period (usually one year). Real (constant price) GDP reflects total economic activity after adjusting for inflation. There are three approaches to estimating GDP: o production or output method sums the value added (value of production less input costs) by all businesses (agriculture, mining, manufacturing, services);. o expenditure method adds all spending: private consumption such as food and clothing; government consumption such as remuneration of public sector employees; investment such as factories, manufacturing plants; and exports (foreigners’ spending) less imports (domestic spending abroad). o income method aggregates the total incomes from production and includes employees’ wages and salaries, income from self-employment, businesses’ trading profits, rental income, trading surpluses of government enterprises and corporations. Theoretically the output, expenditure and income measures of GDP should be identical (see 2.3). In practice discrepancies exist due to shortcomings in data collection, timing differences and the lack of informal sector data. Presented as: Quarterly and annual totals Focus on: Percentage changes, annual or over four quarters Timing: Coincident indicator of the business cycle Interpretation: Interpretation of GDP numbers depends on business cycle timing. For example strong economic growth after an economic recession usually indicates the utilisation of idle capacity; during the expansion phase it may suggest the installation of new and additional capacity to add to future production while at the peak it may imply inflationary pressures. Likely impact on: Interest rates High GDP growth could be inflationary if the economy is close to full capacity. This will lead to rising interest rates as market participants expect the central bank to raise interest rates to avoid higher inflation. Bond prices Higher interest rates mean falling bond prices. Share prices High growth leads to higher corporate profits – this supports share prices. However inflationary fears and higher interest rates usually impact share prices negatively. Exchange rate Strong economic growth will tend to appreciate the exchange rate as higher interest rates are expected. South African GDP (see figure 2.6) has been sluggish on a quarter-to-quarter basis post 2013. Growth in real GDP moderated from year-on-year 1.5% in 2014 to an unsatisfactory year-on-year 1.3% in 44 2015, which with the exception of 2009 is the slowest rate of expansion during the past 17 years. The disappointing performance

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