Economy’s Effects on the Stock Market

Introduction

In any stock market analysis the impact of monetary and fiscal policies of the nation cannot be ignored as they have an overwhelming impact on the movement of stock market prices. The stock market can not be regarded as the ‘cause’ of the growth of an economy, but in essence is the indicator of the economic growth of any nation. It is possible to measure the impact of public policies on the economic growth of a country by studying the consequent changes in its stock market position. Though the stock markets are ‘informationally efficient’ in that every day events and news are reflected in the stock market.

Some of these news and events may represent changes in the economic and financial fundamentals. The fundamental changes in the economic structure and policies are considered as one of the important factors that determine the long-term movements of the stock markets. While the every day news and events largely influence the day-to-day fluctuations in the stock market the long-term changes in the stock market structure and capitalization can be directly related to the fundamental economic variations.

It may be noted that the average prices in a stock markets over a period of one year may not be considered as having been influenced by the daily news and events but instead by the effects of the economic fundamentals. There are some distinct elements of the economy that cause movements in the stock market. This paper discusses these factors in detail.

Interest Rates

One of the important elements of the economic changes that affect the movement of the stock market is the changes in the interest rates. The central bank of a country normally raises or lowers the interest rates to stabilize or stimulate the economic conditions prevalent in the country. This is known as the monetary policy. When the interest rates are raised they have an indirect effect on the interest rates charged by the banks to the customers on their borrowings.

This impacts the amount of money that people can spend and therefore a reduction in the disposable income of the people. This has its effect on the performance of the business by way of reduced earnings due to higher interest rates and reduced sales due to lesser disposable income in the hands of the consumers. The reduced earnings and sales growth affects the future expected cash flows from the company which is an important factor in the valuation of the shares of a company.

All other things being equal this causes a consequent reduction in the share prices and if there is a decline in the prices of the shares of a number of companies the share market index which the people use to equate the stock market movements also goes down. Since the investors would like to see that their investments grow in value, a declining stock price movement is not a desirable scenario. “With a lowered expectation in the growth and future cash flows of the company, investors will not get as much growth from stock price appreciation, making stock ownership less desirable” (Investopedia).

Economic Outlook

The economic outlook represents a prediction of the movement of the economy of a nation for a reasonable future period. The economic outlook also largely influences the movements in the stock markets of any country. If the economic outlook of a country is bright and a buoyant economy in terms of GDP and employment rates is predicted, it enhances the investors’ confidence. The investors will buy more stocks thinking that they will be able to maximize their earnings and increase the value of their shareholding (Investor Education Fund).

This increases the stock market movement in a positive direction with the prices of the shares of the individual companies rising. On the other hand if a gloomy economic outlook is predicted and a slow down of the economy is suggested, the stock market may move in a negative direction.

Inflation

The relation between inflation and the stock market can be explained by its impact on the stock prices. Typically higher inflation rates tend to lower the equity prices. Essentially the investors buy stocks to receive earnings by way of dividends in the future. Assuming the present value of cash flows at a certain point, when the price levels increase the market assumes that there will be an increase in the interest rates too. As we saw earlier an increase in the interest rates will result in the reduced stock prices. Further with the increase in the interest rates the investments in the bonds become more attractive than investment in the stocks.

Higher inflation rates create uncertainty in the economy and the increased uncertainty forces the investors to expect higher risk premiums signifying higher returns on equity. Assuming that the future cash flows on these stocks do not change a higher return is possible only if the stock prices decline now (B.Venkatesh).

Deflation

Deflation refers to falling prices over a period of time. The fall in prices may be the direct result of improvements in productivity, developments in technology, changes in the government policies and a drop in the prices of inputs for production of goods and services. Deflation may also arise if the consumers reduce their spending on the expectation that the prices will continue to fall or because of insecurity feeling of the future economic conditions (Douglas H. Brooks and Pilipinas F. Quising)

Since under deflation the cost of goods and services will be lower, with a dollar more volume could be purchased. There is bound to be an increase in the interest rates and the spending of the people will become less. Deflation increases high real interest rates and may thus lead to a depressed investment state. There will be lower demand for goods and services and increased unemployment.

Under deflation there would be large transfers of wealth from the debtors to the creditors which reduce the ability of the economy to keep the system of credit and financial intermediation functioning in tact. This disruption in the financial system brings additional downward pressure on the investment, demand, and unemployment which will have their own effect on the stock price movements. These will have a negative impact on the stock market prices.

Economic Shocks

Economic changes are major changes in the economy of any country or the world. Such changes do affect the economy and the stock market prices.

The economic shocks may happen either on the demand side of the economy or on the supply side. The demand side economic shock results in adversely affecting the aggregate demand of the country which in turn reduces the consumer spending and investments (Economic Essays).

In order to control the demand side economic shocks the government may introduce expansionary fiscal measures as a suitable monetary policy. Lowering the income tax rates, increased personal disposable income characterizes the changes due to the adoption of expansionary measures. This encourages consumer spending. However if the confidence level of the investor is low then any reduction in the income tax rate may not be found to mitigate the issues relating to the aggregate demand. Thus demand side economic shocks will lead to a reduction in the stock market prices. On the other hand, the supply side economic shock has its impact on the aggregate supply.

For example the increase in the oil prices is a supply side economic shock. With the increase in oil prices there is bound to be lower economic growth and higher inflation due to reduction in the production, output, and consumer demand. This affects a number of companies and consumers which results in lower sales, lower profits, and consequent lower stock prices. Another example of economic shock is an act of terrorism which would result in a downturn in the economic activity and also a fall in the stock prices.

Changes in the Governments

Any change in the government would imply changes in the monetary and fiscal policies of the government as such policies would naturally depend on the ideology of the political party that comes to power. The monetary policies of the changed government for instance may greatly increase the government spending on populist measures. Rise in the government purchases normally tend to have the effect of increasing the real GDP through the exchange multiplier.

An increase in spending that has the effect of increasing the real GDP of the country will also lead to a consequent increase in the stock prices. Similarly a reduction in the government spending which has the effect of reducing the real GDP would naturally make the share prices fall resulting in still greater decline in the real GDP. Thus the decisions of the changed government in policymaking may lead to the changes that may bring good to the business and sometimes they may also produce adverse impact on the business. The changed policies may also direct the economy towards inflationary trends and enhanced interest rates. In any case due to changes in governments there would be changes in the economy and the consequent impact on the stock prices.

Currency Value

The countries always indulge in the import and export trade with the other countries and as a result there is a constant flow of foreign exchanges from and to the countries. As a result of changes in the value of the currency it may so happen that the customers may have to spend more to buy the imported goods. This sometimes would result in reduced sales and consequently may lower the stock prices. On the other hand if the value of one currency falls it may become cheaper to buy the products of that country. This may make the stock prices go up.

Fundamental Analysis of Stock Market

The traders in stock market futures generally take their positions on the basis of an analysis of the possible cause and effect of certain factors on the stock prices (Investopia).

The analysis may take two different forms namely the fundamental analysis and the technical analysis. While the fundamental analysis concentrate on the effect of causes external to the trading in the stock markets the technical analysis involve a study of the historical price movements of different stocks to determine the possible course of future stock market prices. The fundamental analysis mainly takes in to account the likely economic impact on the share price movements. The fundamental analysis includes among other things, the analysis of weather conditions, current inventory levels, government policies, economic indicators, trade balances, and the likely reaction of the traders for economic events and shocks.

Thus the fundamental analysis basically takes into account mainly how the economy would affect the stock price movements by the changes in its various facets. The supply and demand position of goods and services, the agricultural fundamentals, and the live stock fundamentals are some of the factors the fundamental analyst takes into account in arriving at the future changes in the stock market situation which in turn depends to a large extent on the economic conditions prevailing in the country.

Conclusion

The paper thus has detailed the different economic factors that are likely to change the course of the stock market in the long-term. Since the stick market reacts wildly to the occurrence of any events, the day-to-day events and news affect the stock price movements in the short run. The long-term trends of the stock markets are determined by the economic indicators like inflation, deflation, changes in the monetary and fiscal policies of the government and many such factors discussed in this paper. Despite the knowledge on so many factors and events that have an impact on the stock prices, sometimes it becomes highly difficult to attribute any particular reason as to why the stock markets behave in a certain way which still poses a challenge to the intelligence of the economists and the stock market analysts.

Work Cited

B. Venkatesh ‘Inflation and Stock Prices’. The Hindu Business Line Newspaper. 2004. Web.

Douglas H. Brooks and Pilipinas F. Quising ‘Dangers of Deflation’. Web.

Economic Essays ‘Can Government’s Deal with Economic Shocks’. Web.

Investor education Fund ‘Chapter 5: How Does the Economy Affect Stock Investments’. Web.

Investopia ‘Fundamental Analysis’. Web.

Investopedia ‘How Interest Rates Affect the Stock Market’. Web.