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Understanding financial markets

The assets traded on financial markets include equities, bonds, currencies and commodities. Although these are very different types of assets, they are all affected by certain key factors.

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise.

Interest rates are the lynchpin
Interest rates are one of the most important factors driving financial markets.

Central banks such as the Bank of England or the European Central Bank will lend money to commercial banks at what are known as ‘base rates’. These are the lowest rates in the market and are also known as the ‘bank rates’ or the ‘base interest rates’.

These rates are the starting point for the business conducted by banks. The interest they offer on their deposit accounts and the interest they charge on mortgages are usually linked to these rates.

Central banks will regularly announce updates on the base rate. The Bank of England announces the rate each month after a meeting by its Monetary Policy Committee.

Generally, if interest rates rise in a country then this will weigh on the prices of other financial assets. This is because bank deposits become relatively more attractive, driving money out of financial assets such as equities and bonds and into savings accounts, for example.

Higher interest rates also make it more costly for companies to borrow money to invest and attract money out of the economy into bank deposits, undermining the business environment for companies.

But higher interest rates strengthen the domestic currency. Foreign investors will want to deposit their capital in UK banks if higher interest rates are available, for example, thereby increasing the demand for (and price of) sterling. This helps keep down inflation too as foreign imported goods, which are included in the inflation measures, become less expensive.

Economic indicators
Economic data is regularly announced by government statistics agencies. In the UK, this is the Central Statistics Office.

Anything that boosts the economy helps the business environment and supports stocks. Anything that dampens economic activity, such as tax rises, hampers business activity and weighs on stocks.

The main types of data include:

  • Gross Domestic Product (GDP), which is the national economic output
  • Inflation, stated as the Consumer Price Index and the Retail Price Index
  • Unemployment rate
  • Money supply. There are several measures of this. The narrowest, M0, is the stock of physical pounds and coins plus banks’ cash held at the Bank of England. There are broader measures of money supply, such as M4, which also includes the money held on all bank accounts and denominated in electronic format

All the above data provide guidance on the state of the economy. If the economy is strengthening, then this will boost the business environment for many of the companies listed on the stock market and positively impact their profits and share prices. The reverse is also true.

If the economy is strengthening too much, however, then this might raise fears that the economy is over-heating and inflation could result. In such a scenario, the central bank might raise the base interest rate to dampen the economy.

Currency movements
Inflation means that the real spending power of a currency is reduced. If a currency becomes weaker then its exchange rate is more likely to fall versus foreign currencies.

Central banks can strengthen or weaken the value of their domestic currency by raising or cutting interest rates: higher interest rates will attract foreign capital from investors seeking higher returns on their deposits and vice versa.

Commodities can cause inflationary challenges
The prices of commodities, such as oil, gas, precious and industrial metals and coffee, sugar or cocoa, rise or fall according to supply and demand.

Commodity prices are driven by global economic factors. For example, if the demand for industrial metals such as copper rises because of stronger economic output in China, then this will drive up prices. Or if the supply of coffee rises because of bumper harvests in a particular year then this will drive prices down, assuming world demand remains constant.

As the raw materials used widely in the economy, commodities can have a major impact on inflation. Rises and falls in their prices can cause inflationary headaches that are often beyond the control of individual governments. More information on commodities is available here. 

Markets are forward thinking
The professionals who trade and invest use the above indicators and many others to anticipate the future direction of financial markets. These expectations are factored into the current prices of assets. If expectations change then the current prices of assets will change too, which helps to explain why financial markets can be so volatile.

Short-term traders aim is to make money by anticipating rises in the prices of certain assets and then selling them when the market realises the true value, a practice known as ‘buying on the rumour and selling on the fact.’

For most investors, the goal is to identify assets that will appreciate over the longer term.

For more information on constructing an investment portfolio, see here. 

Understand common financial words and terms See our glossary

How to invest in Liontrust funds

Through a fund platform
Through a financial adviser
Direct with Liontrust