A prudent investor should attempt to understand the current economic situation as well as its impact on various asset classes. An economy will boom and bust as business activities expand and contract. An economic cycle typically takes 4 to 6 years to complete and composes of five phases.
The economy starts to witness growth while inflation remains low along with rising consumer and investor confidence. Bond prices stay flat or slightly decrease but commodities and stocks tend to perform well.
The economy is still growing but under severe inflation pressure fueled by a continued surge in consumer and investor confidence. Fiscal and monetary policies turn towards tightening with the hope of an economic soft landing. Bond prices fall and while the stock market remains on an uptrend, it is extremely volatile.
Slowdown in economic growth but inflation remains high and consumer confidence begins to decline. Monetary policies stay on the tightening side to control inflation, causing a surge in short-term interest rates. The long-term interest rates, on the other hand, decline amid a coming economic downturn, causing an inverted yield curve. Long-term bond prices rise and stock prices fall from the peak.
The business activities contract usually during two consecutive quarters of decline in real GDP. Consumer and investor confidence is extremely weak. Government will pursue expansionary fiscal and monetary policies to boost the economy as inflation eased. Bond prices continue to rise, stock markets hit new lows, but often bottomed out before the economic recovery because traditional wisdom tells us that the stock market is a leading economic indicator.
The worst is over and the economy regains momentum. Inflation stays low along with easing monetary policies, consumer confidence begin to rise. Stock market surges as economy appears stronger but bond prices start to fall.
Inflation refers to the general and persistent increase in price levels for the goods and services. Using economic indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI), central banks will establish interest rate targets intended to keep the economy in balance. Basically, they will increase interest rates to cool inflation. As interest rates increase, consumers tend to have less money to borrow and spend. With less spending, economy slows and inflation decreases. The opposite holds true for lowering interest rates, where consumers borrow more. With more money to spend, economic growth and inflation will rise.
Global investors and traders keep a close eye on the central banks’ rate decisions, especially the decision by Federal Open Market Committee (FOMC) in United States. The FOMC holds eight regularly scheduled meetings during the year and other meetings as needed. After the meetings, an announcement is made regarding the Fed's decision to increase, decrease or maintain key interest rates. Certain markets may move in advance of the anticipated interest rate changes and in response to the actual announcements. For example, the U.S. dollar typically rallies in response to an interest rate hike.
Numerous studies have looked at the impact of inflation on stock returns. Unfortunately, these studies have produced conflicting results when several factors are taken into account - namely geography and time period. Most studies conclude that expected inflation can either positively or negatively impact stocks, depending on the ability to hedge and the government’s monetary policy. But unexpected inflation did show more conclusive findings, most notably being a strong positive correlation to stock returns during economic contractions, demonstrating that the timing of the economic cycle is particularly important for investors to gauge the impact on stock returns. This correlation is also thought to stem from the fact that unexpected inflation contains new information about future prices. In addition, greater volatility of stock movements is often associated with higher inflation rates.
As for bond markets, there is an inverse relationship between Interest rates and bond prices. The question is: how does the prevailing market interest rate affect the value of a bond you own or a bond you want to buy? The answer lies in the concept of opportunity cost. Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond's coupon rate – which is fixed – becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Generally, if the central banks increase rates unexpectedly, both stock (in the short-term) and bond markets will suffer.
Example of Changes in Bond Price Due to Changes in Interest Rate:
Calculating bond price is simple: all we are doing is discounting the known future cash flows. The price of a bond is the sum of the present values of all expected coupon payments plus the present value of the par value at maturity.
Assuming a 10-year bond with a par value of $1,000, the coupon rate is 3% and paid semi-annually (that is the bond will be paid $15 semiannually). If the market interest rate is also at 3%, the bond price should equal to the par value - that is $1,000.
If market interest rates immediately increase to 4%, we will discount the coupons and par value at 4% and such the bond price will fall to $918. Conversely, if interest rates falls to 2%, the bond price will rise to $1,090.
There are no hard rules on how to classify between emerging, developed, developing, and frontier market. Generally, three highly regarded organizations provide some common categorization. They are the International Monetary Funds (IMF), The Organization for Economic Cooperation and Development (OECD) and the World Bank.
Developed market is a country with a highly industrialized economy, typically with a large service sector. A developed country will tend to have a high GDP per capita income, and built out infrastructure (transportation, communications) compared to a developing country.
Developing market has low levels of living and productivity, rapid population growth, underdeveloped industry and a reliance on agriculture and exports for economic sustainability. Surprisingly, China is often classifies as developing market because, while it has the second highest GDP in the world, it also has the largest population, thus its GDP per capita is nowhere near the level in US.
Emerging market is a developing market that is moving towards becoming a developed market, typically with annual GDP growth in the high single digit or even doubles digits. These nations no longer rely primarily on agriculture; have impressive infrastructural and industrial growth with unprecedented development in energy, information technology and telecommunications.
Frontier market is a relatively small country with less established capital markets with political instability, poor liquidity, inadequate regulation, substandard financial reporting and large currency fluctuations. Thus, it has highest investment risks though it generally has a lower correlation to the rest of the world and can provide additional diversification.