What Is a Stimulus Package and How Does it Affect Investors?
If you have read or watched any news recently, you will have almost definitely heard the term “stimulus package”, or “stimulus plan”, in relation to economies which have been ravaged by the coronavirus pandemic.
But do you understand exactly what this term means? More importantly, do you understand how a stimulus package can affect the financial markets and, consequently, your trading and investing? If not, you have come to the right place! In this article, we will explain what a stimulus package is and how it can affect the financial markets.
Table of Contents
What Is a Stimulus Package?
A stimulus package is a collection of measures introduced by a government or central bank to intervene in a struggling economy and promote growth, or counteract economic contraction. As the name suggests, its purpose is to breathe life into an economy which is suffering or in recession.
It is for this reason that the topic has been in the news so much of late. As worldwide economies have been devastated by the coronavirus pandemic, many governments have turned to interventionist measures to provide relief to individuals or businesses who require it and, in doing so, attempt to provide impetus to the economy.
The argument behind government intervention in times of economic crisis is that increased government expenditure, together with other measures such as lower taxes, can help stimulate consumption and investment thus pulling the economy out of recession. This is one of the central tenets of Keynesian economics, which argues that economies are not always self-correcting and, therefore, require government intervention in times of economic downturn.
So, how exactly can the government and central bank intervene in the economy? What does a stimulus plan actually look like? And what does it mean for traders and investors?
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How Does a Stimulus Plan Work?
A stimulus plan can be implemented through monetary policy, by a central bank, or fiscal policy, by the government.
A central bank has two main methods at its disposal for influencing the direction of the economy: interest rates and quantitative easing.
Interest rates are a powerful tool for influencing the economy’s behaviour. Lower interest rates reduce the incentive for people and organisations to save money in the bank, simply because they will earn less interest by doing so. Therefore, there is an increased incentive to either spend this money or invest it.
Furthermore, lower interest rates also mean that borrowing money is cheaper, which encourages more people and businesses to borrow, increasing the amount of money in circulation.
In many countries, including the UK, interest rates have remained very low since the ‘Great Recession’ of 2008, meaning that there has been less scope for central banks to reduce rates further. This has led to calls in some countries to introduce negative interest rates.
Quantitative easing is essentially a method whereby the central bank pumps more money into the economy to try and stimulate consumption and investment.
The central bank does this by purchasing large amounts of financial assets - such as bonds - from other financial institutions or the government. This practice increases the money in circulation in the economy and facilitates more lending from other financial institutions.
As well as pumping more money into the economy, quantitative easing increases competition in the purchase of government bonds, reducing returns. This, in turn, encourages professional investors to invest in riskier assets - such as equities. Both of these effects can have a stimulative impact on the economy.
The government’s aim when undertaking fiscal stimulus is to increase the money in circulation in the economy. It has two different ways of doing this.
The first is by reducing taxes, which increases peoples’ disposable income, giving them more money to spend which will hopefully lead to an increase in consumption.
The second method is for the government to increase its spending in a bid to counteract the recession. In times of particularly poor economic performance, the government may choose to increase its spending in the form of relief payments to individuals or businesses, as we have seen throughout the coronavirus pandemic.
For example, in the US, the government has provided individual citizens with stimulus cheques as part of their overall stimulus packages. In the UK, on the other hand, more assistance has been provided to businesses in the form of cheap loans and through the furlough scheme, whereby businesses have been able to retain their employees with the government taking responsibility for paying part of their wages.
A less direct way for governments to implement fiscal stimulus is to spend money on public works. Many large infrastructure projects, like dams, railways and tunnels, have been initiated by governments as a way of injecting money into a sleepy economy.
The risk of fiscal stimulus is that, instead of increasing consumption, individuals may be inclined to save the extra disposable income they have received through tax breaks or stimulus payments.
How Do Monetary and Fiscal Stimulus Affect the Financial Markets?
So now we know what measures are available for governments and central banks to employ as part of their stimulus plan, what effect do they have on the financial markets?
The Forex Market
We will start by looking at the foreign exchange, or Forex, market which is the most heavily traded financial market in the world.
The value of a country’s currency against that of another is determined by a variety of different factors. One of the most important of these is interest rates.
There tends to be a positive correlation between interest rates and currency value, meaning that higher interest rates can lead to a higher valued currency and vice versa.
This relationship can be explained by two main factors, the first of which is foreign investment. Lower interest rates reduce potential returns and, thus, make the country a less appealing prospect for foreign investors.
Any subsequent fall in foreign investment translates into a fall in demand for a country’s currency and, therefore, a fall in its value. The opposite is also true: higher interest rates lead to increased foreign investment and an increase in value of the domestic currency.
The other important factor which explains the relationship between interest rates and the Forex market is inflation. Inflation measures the rate at which a currency’s purchasing power is declining and prices are subsequently rising.
Reduced interest rates lead to an increase in consumption, however, if left unchecked, this increased consumption can lead to demand outstripping supply and, subsequently, an increase in inflation. So, as reduced interest rates increase the risk of inflation rising, they will also lead to the currency in question to weaken on the Forex market. Of course the opposite is true with higher interest rates.
For example, if the UK increased its interest rate to a level significantly higher than that of Japan, you could expect, all other things being equal, that the currency pair GBP/JPY would appreciate over time as the GBP increases in value over its Japanese counterpart.
Quantitative easing causes an increase in the money supply and, therefore, an increase in consumption. However, as with any asset, an increase in the supply of money will eventually lead to a decrease in its value.
Therefore, as with low interest rates, quantitative easing can lead to an increase in inflation as the supply of money in circulation increases and, as we have already seen, an increase in inflation will lead to the devaluation of a currency.
Fiscal Stimulus Measures
Fiscal stimulus, whether lower taxes or higher expenditure, tends to rapidly increase government debt.
High levels of government debt will likely increase the supply of government bonds (the main form of government debt), and this increased supply will make government bonds less attractive to foreign buyers.
High levels of government debt also increase the risk of future inflation.
Both, the decrease in foreign investment and the prospect of future inflation, will exert downward pressure on a country’s currency.
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Equities and Bonds
The reduction of interest rates increases the incentive to spend money but also to invest it, in the hope of achieving a higher return than that of the current interest rate. Conversely, higher interest rates increases the incentive to keep money in the bank as opposed to investing it.
A second powerful effect adds to this. Many professional investors use discounted cash flow (DCF) calculations as a method of valuing equities and bonds. In these calculations, lower interest rates will increase the value of shares and bonds (and vice-versa).
Therefore, interest rates play a large role in influencing the equity markets. During times when interest rates are low, you can expect a greater flow of money into the equities market and vice versa.
If low interest rates lead to the devaluation of the currency, this will be detrimental to the stocks of companies which rely on imports.
However, a weaker currency is beneficial to exporting companies, as their goods become cheaper to foreign consumers.
Low interest rates then, will benefit the shares of exporting companies in three different ways: by increasing investment appetite, by increasing the values shown by DCF models and by lowering the cost of exports. The likely positive effect on share prices will also be seen in indices which are dominated by export-centred businesses, such as the FTSE 100.
In contrast, the effect on bonds will be more complex and difficult to determine. In general, lower interest rates will increase prices of existing bonds but make future bonds less attractive.
Because the central bank is increasing the money supply primarily by purchasing bonds, this surge in demand for bonds results in bonds increasing in value. This subsequently lowers their yields and thus makes the bond market less attractive to investors.
Therefore, quantitative easing not only benefits the equities market due to the increased capital in circulation, but also by simultaneously making the bond market less appealing.
Fiscal Stimulus Measures
Increases in disposable incomes and government spending will benefit equities markets as more money in the economy stimulates the purchase of goods and services made by listed companies.
However, in order to increase spending, whilst reducing revenue through lower taxation, the government must raise funds and indebt itself through the sale of bonds.
This increase in government bonds will lead to lower bond prices and consequently higher yields, making bonds a more attractive option for investors. This increased interest in bonds can be detrimental to equities.
Where governments’ fiscal stimulus takes the form of direct expenditure, like construction, new infrastructure, or energy subsidies, it can have a very direct impact on the equity prices of companies which form part of the relevant industry.
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How to Trade the US Covid Stimulus Package
Given what we now know about stimulus packages and their effect on the financial markets, how can we apply this to the recently approved US stimulus plan?
The proposed package is worth around $1.9 trillion and will largely take the form of stimulus cheques for US citizens but also money for small businesses, tax credits and other benefits.
With an increase of this size in the money supply, you would expect the US dollar to weaken against other major currencies, a pattern it has followed since the outbreak of the pandemic. In no other currency pair has this been more prevalent than the EURUSD, so we could see even further gains in the euro against the US dollar in 2021.
However, a fall in the US dollar will benefit US exports, which will become relatively cheaper to foreign consumers. The shares of exporting companies, therefore, are likely to benefit from a weaker US dollar.
Technology giant Apple, which is one of the biggest exporting companies in the US with around 60% of their revenue accounted for by foreign sales, could be one company which will benefit from the stimulus package and a weaker US dollar.
A weaker US dollar may also benefit the commodities market, which is largely priced in US currency. Commodities which are priced in US dollars, will become cheaper for foreign consumers which could lead to increases in demand.
Copper - which is already trading at a nine year high, reflecting the optimism that economies will soon bounce back from recent slumps - could be a commodity which will benefit further from a weaker US dollar.
You should now be more familiar with what a stimulus package is, how it is carried out, by both central banks and governments, and how it can affect the financial markets and consequently your trading and investing.
Whilst the exact impact of the USA’s latest stimulus plan will not be certain until it has come into effect, one thing you can be sure of is increased uncertainty and, therefore, volatility in the stock market in the lead up to the package being enacted.
Increased volatility comes with increased risk, however, it also presents opportunities for traders to attempt to make a profit from both rising and falling markets. If you are somebody who trades volatile markets, remember to always implement good risk management.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.