Stocks and Bonds An Analysisof the UK investment scene

全路思

（金華职业技术学院）

Current Economic Climate in the UK

The UK is considered as one of the fastest growing economies in the advanced world （Wall， 2014）. For the period January to March 2014， the economy grew by 0.8% which is just 0.1% below the expected 0.9%. This resulted in the devaluation in the pound sterling in comparison to other major currencies （BBC， 2014）. Surveys of 675 firms revealed that there is a strong belief that the economy will continue along this growth path throughout 2014 （BBC， 2014）. Growth prospect is especially strong within the manufacturing industry. The rate of inflation has remained steady at about 1.6% which increases the probability that current bank interest rates will remain at 0.5% until the third quarter of 2015 （This Is Money Reporter， 2014）.

So far in 2014， market equities have performed below expectations despite the optimism in the marketplace （Wall， 2015）. This optimism is due mainly to the exceptional performance of companies within the Pharmaceuticals industry in general and Astrazeneca stocks in particular. The current market volatility is low due to the relaxed monetary policy and gentle credit conditions. However， stocks are prone to increased volatility if the violence in the Ukraine affects economic conditions in the UK （Wall， 2015）. The optimal portfolio allocation however， is based on investor sentiments about the performance of the economy and other underlying states. This means that an investor who expects that returns will generally be low and who adopts a buy and hold strategy， will tend to avoid investing in stocks and bonds in the short run. However， this investor will opt to invest in more stocks over the long run as the expectation for the economy to become more bullish increases （Guidolin & Timmermann， 2005）.

The aim of investment is to make a return upon that investment. Of course， an investors level of risk， investment time horizon and perceptions about the economy as well as perceptions about the entity that is issuing the security， will play a large role in determining whether or not one invests. This paper will consider stocks and bonds as investments in the current economic climate in the UK.

Investing in Stocks

Stocks are risky investments that are more suitable for investors with a longer term investment horizon. Income from stocks may be in the form of dividends or in the form of capital gains when the stock price increases and the stock is sold for a price that is greater than the price at which it was bought. According to the Efficient Market Hypothesis （EMH）， stock returns are impacted only very slightly by the expected inflation rate. However， there is a negative relationship between the unexpected inflation rate and stock price. This means that in the long run， an increase in the inflation rate leads to a decrease in the stock price （Li， Narayan & Zheng， 2010）. The rate of inflation in the UK has been on a downward trend and is expected to continue into the rest of 2014. Therefore， equity investors should not expect inflation to affect the return on any equity investments in the near term.

Given the positive outlook for the UK economy in terms of growth， it is expected that companies， and especially those in the manufacturing industry， should see improvements in firm performance in the short term， all other things being equal. As a result， investor sentiment regarding stocks will be largely influenced by company fundamentals. As investor confidence increases， the price of stocks are expected to increase accordingly which results in capital gains. Similarly， as firms make greater profits， their ability to pay dividends and to increase dividend payout increases. Companies in the manufacturing sector could prove to be good investments given this expected positive outlook for the sector. These stocks should see good dividend yields during the next 12 month period. Similarly， there is a negative 0.90 correlation between a firms PEG ratio and the expected rate of return on stocks （Easton， 2004）. Therefore firms with low PEG ratios should prove to be good investments that will produce good returns.

On the other hand， the violence in the Ukraine could negatively affect economic growth in the UK which will have the domino effect of negatively affecting firm performance which will negatively affect stock prices and dividend payouts. Therefore， investors should proceed with caution if they are seeking to use equities for income or growth purposes. Instead of adopting an active investment policy where stocks are actively traded， it may be a better idea to buy and hold for the long term. This will hedge against risks of loss in the short term.

Investing in Bonds

Corporate Bonds are affected by systematic risk （Gedhardt，Hvidkjaer & Swaminathan， 2005）. Systematic risk is the risk that is associated with factors external to the firm such as inflation， taxes， monetary policy， and the political climate （Reilly & Brown， 2011）. This means that bond prices and bond yields are affected by the inflation rate， interest rates， and the tax rate. A bonds rating and duration reflect the systematic risk inherent in the bond （Gedhardt， Hvidkjaer & Swaminathan， 2005）. In addition， many corporate bonds are secured by real assets. Therefore， corporate bonds are suitable for investors who have low risk tolerance and relatively long term investment horizons of between 10 and 20 years.

Conclusion

Equities are variable return instruments with a relatively high level of risk and a corresponding greater return. These securities are affected slightly by inflation rates but are very responsive to economic conditions such as rate of economic growth. Return on equities and rate of economic growth are positively correlated. Given the UKs falling inflation rate and growing economy， equities may prove to be good investment options for the more risk loving investor in the next 12 month period. However， there is some economic uncertainty associated with the violence in the Ukraine which could negatively affect stock returns of UK investors. Corporate Bonds on the other hand are fixed income instruments that have medium to long term investment horizons usually between 10 and 20 years. They are less risky than equities and the return is therefore usually less than the return on equities. Corporate Bond returns are affected by inflation rates and interest rates. The UKs falling inflation rate and steady interest rates make corporate bonds attractive options for investors that are more risk averse than equity investors. Ultimately， the investors choice of equities or bonds is dependent upon their risk level， and their investment horizon. The UK presents good opportunities for both the risk averse investor and the risk loving investor.

References

[1] BBC （27 April 2014）. Economic outlook is ‘exceptionally strong says CBI， Retrieved from www.bbc.com/news.

[2] Easton， P.D. （2004）. PE ratios， PEG ratios， and estimating the implied expected rate of return On equity capital， The Accounting Review， 79（1）， 73-95.

[3] Financial Times （26 April 2014）. Is there life for bonds in the UK after annuities？ Retrieved From gulfnews.com.

[4] Gebhardt， W.R.， Hvidkjaer， S.， & Swaminathan， B. （2005）. The cross-section of expected Corporate bond returns： Betas or characteristics？ Journal of Financial Economics， 75（1）， 85-114.

[5] Guidolin， M.， & Timmermann， A. （2005）. Economic implications of bull and bear regimes in UK stock and bond returns， The Economic Journal， 115（500）， 111-143.

[6] Li， L.， Narayan， P.K.， & Zheng， X. （2010）. An analysis of inflation and stock returns for the UK， Journal of International Financial Markets， Institutions and Money， 20（5）， 519-532.