Macro economic factors affecting equity / other asset prices
Interest rates- are the most important Macro economic factor affecting asset prices. Even a one basis point change in interest rates affects equity prices. An increase in interest rates causes a decrease in asset prices and a decrease in interest has an opposite effect. This can be understood by the ongoing sub prime crisis in U.S.. The decreasing interest rates in U.S. in the Greenspan years from 2000 to 2003 ( for which now he is drawing a lot of flak ) when Fed interest hit a low of 1% fuelled an unsustainable boom in housing market in U.S. & housing & other asset classes globally. Then as the economy in U.S. as well the global economy came out of the slump caused by the dot com bubble burst of 2000 from 2003 onwards, Fed interest rates were increased to a high of 5.25% in 2007. This delt a death blow to the housing bubble in U.S., U.K. & other developed countries. A similar impact was on equities as well, especially the emerging market among them the so called BRIC countries. Suppose the interest rate is 5 % & a co. X has a share price of Rs 100 & an EPS of Rs. 5. then an owner of this share is getting a 5% return, the same as the debt investor- as just like water, returns tend to keep level . Suppose now the interest rates double ( in our case in the U.S. economy they increased over 5 times as stated above). Now since a debt investor is getting a 10% return, the equity investor return should match over time. This can happen in two ways- first, the share prices falls by 50% to Rs 50 or the EPS doubles to Rs 10. The first scenario is what happens in case of most cos. as it is very difficult to increase earnings in an increasing interest rate scenario. Hence the sub prime crisis & falling equity prices.
Interest rates- are the most important Macro economic factor affecting asset prices. Even a one basis point change in interest rates affects equity prices. An increase in interest rates causes a decrease in asset prices and a decrease in interest has an opposite effect. This can be understood by the ongoing sub prime crisis in U.S.. The decreasing interest rates in U.S. in the Greenspan years from 2000 to 2003 ( for which now he is drawing a lot of flak ) when Fed interest hit a low of 1% fuelled an unsustainable boom in housing market in U.S. & housing & other asset classes globally. Then as the economy in U.S. as well the global economy came out of the slump caused by the dot com bubble burst of 2000 from 2003 onwards, Fed interest rates were increased to a high of 5.25% in 2007. This delt a death blow to the housing bubble in U.S., U.K. & other developed countries. A similar impact was on equities as well, especially the emerging market among them the so called BRIC countries. Suppose the interest rate is 5 % & a co. X has a share price of Rs 100 & an EPS of Rs. 5. then an owner of this share is getting a 5% return, the same as the debt investor- as just like water, returns tend to keep level . Suppose now the interest rates double ( in our case in the U.S. economy they increased over 5 times as stated above). Now since a debt investor is getting a 10% return, the equity investor return should match over time. This can happen in two ways- first, the share prices falls by 50% to Rs 50 or the EPS doubles to Rs 10. The first scenario is what happens in case of most cos. as it is very difficult to increase earnings in an increasing interest rate scenario. Hence the sub prime crisis & falling equity prices.
Q.E.D.
Pl. refer to earlier blog Cinderalla story.
To be continued.
Pl. refer to earlier blog Cinderalla story.
To be continued.
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