The Relationship Between Stock Market Prices

Published Date: 02 Nov 2017

Describe and assess the relationship between stock market prices and macroeconomic variables

Introduction

It is quite difficult to pinpoint the movement of stock markets as they arguably follow a random walk as explained by the efficient market hypothesis that all macro and micro economic information is incorporated into the stock price. Sometimes a lot of information is flooded into markets especially during times of panic. This will cause expectations to change and cause contagion within markets which could either increase or decrease stock market indices.

Interest rates

The interest rate is the cost of borrowing funds. Interest rates are set by central banks such as the Federal Reserve and the Bank of England and it is changed through quantitative easing or tightening (the change of money supply through printing money by buying bonds from banks etc.) When the economy needs stimulation, interest rates are set low in order to encourage cheap borrowing which will allow businesses to expand more. This will directly impact the stock markets as businesses will be realising more wealth creating activities. This would boost their future profitability and increase future potential dividends which will increase stock prices. As interest rates affect the whole economy, there will be a rise in the overall stock market. The opposite occurs when interest rates are increased in order to curb spending and cool down the economy and to reduce the likelihood of hyperinflation as experienced by Germany post the world war. A closely linked macroeconomic variable to interest rates is inflation. It affects the real interest rate as shown through the fisher effect and impacts real wealth in the form of goods and services.

If interest rates have decreased then consumer disposable income rises as there is less interest to pay off on loans. If a company has a loan, as they also pay less interest they can use that money to invest or expand in the business. Consumers have more money to spend on the goods and services a firm produces so revenue increases meaning healthy stock market growth for companies overall.

If interest rates rise investors tend to sell or trade their higher risk stocks for government protected securities such as bonds to take advantage of the higher interest rates that they acquire and to safeguard their investment. Due to risk of slow or no return during the 1973-74 the stock market crash lenders became cautious with loaning money and so increased interest rates to secure a stronger return on cash. This in turn pushed up borrowing costs for companies while having a lower demand which impacted revenue growth. This damaged sentiment for the stock market as a whole. Sentiment indicates business or consumer confidence which can forecast future outcomes of the economy.

"The stock market tends to react negatively to high oil prices" due to the adverse effect on different major industries paying out more for oil. This all resulted in one of the worst stock market crashes in history affecting the major stock markets around the world particularly the UK and US markets.

Inflation

Macroeconomic variables such as inflation can cause substantial fluctuations in the stock market. Inflation is the increase of prices over time of goods and services. Many central banks set a target of maintaining 2% - 3% per year.

When inflation is increased the currency value declines relative to other currencies as the purchasing power of the domestic currency declines. This causes devaluation in the currency. When this occurs it is cheaper for foreign investors to purchase domestic goods and services and this can drive up stock prices.

In the short run, when inflation occurs, real interest rates based on the fisher equation decreases. In order for shareholders to get the same real return, they demand higher returns from stock to overcome inflationary effects. This can be seen using Gordon’s Growth model or the price to earnings ratio method of stock valuation. This causes the stock price to decrease as it is discounted more heavily. However, in the long run, dividends and earnings increase as companies increase their prices and this allows the share price to increase gradually over the long run. Thus, when there is a steady rate of inflation prevailing in the economy, share prices rise over time in order to keep the ratio of the price of the stock and the real interest rate return in harmony. [i] 

(you already talked about this in the paragraph before)

At times of high inflation, accounting rules that do not take into consideration inflationary phenomena will underestimate the depreciation costs of non-current assets, thus increasing the nominal value of assets. This will cause the earnings of the company to be artificially higher, thus increasing stock prices. However, smart investors will need to recognise this problem and re-adjust their valuation of the stock which will gradually stabilise the stock price down. Thus, expectations of inflation play a huge role in the stock markets, as this will alter shareholder’s perceptions of what will happen to their real wealth and this will cause changes in asset prices for all investment products. (EQUITY VALUATION LECTURE SLIDE 19)

However over the long-term the return rate depends on the increase of earnings. This is because during inflation firms can usually raise prices to balance the effects, as peoples earnings would increase. This means earnings and the amount of dividends paid out are likely to increase with inflation. Therefore stock prices will rise because of an increase in earnings with inflation and company growth in general.

If the share prices increase over time due to inflation it increases the taxation of interest income. Companies will shortfall as more money is being spent on resource thus putting the economy in strain due to lower real nominal rate of return leading to share prices to fall. This happens because under prevailing tax rules "inflation raises the effective tax rate on corporate source income" http://www.nber.org/chapters/c11335.pdf.

Overall, the way rate of inflation effects stock prices is by stocks prices to decrease as return rate must increase for shareholders to take an interest in buying new stock. Shareholders expect a higher rate of return because inflation has increased, this allows them to gain the same amount of real wealth. Therefore shareholders present value of dividends decreases therefore stock prices fall. On the other hand over a longer period of time, as firms can pass on costs to end-users and as national exports rise as the domestic currency rates is lower relative to foreign currencies, this would result in earnings to rise. Also assets value can increase; for example machinery and real estates, will usually increase with inflation, sometimes artificially higher than depreciation costs resulting in an increase in company valuations. Therefore stock prices are more likely to rise with inflation over the long-term.  As a result stocks are a good investment opposing to inflation as long as they are acquired for adequate time period.

Combined effects of Inflation and Interest

Many macroeconomic variables such as inflation and interest rates are made up of expectations. Any random changes in these expectations will affect the stock prices. For example, the rational expectations hypothesis of inflation rates describe how all information is used before formulating the expected inflation level. The theory also incorporates a random variable which is seen as random shocks that would affect the inflation rate. These shocks can be due to various things such as the Oil Crisis of 1973. Oil is a major input to the economy and this will have a huge impact on increasing inflation levels. The crisis can be seen as an external shock and this would have translated into stock markets, making the 1973 stock market crash worse. Intuitively, the inflationary shock caused the profitability of firms to be drastically reduced as the nominal value of money rose from $3 in 1970 to around $40 in 1973. [ii] This reduced the real interest rate and triggered contagion and a mass selloff in the markets as investors engage in capital flights to safe havens like gold. Using supply and demand, it is simple to see that if supply of stocks are increasing in the market place due to a mass selloff, then this will drive the price down as the relative amount of buyers are low. In order to entice sales, prices must then be lower.

Exchange Rates

The connection between exchange rates and stock prices is essential as it underpins all international transactions. Various currencies can have a major effect on business exports affecting stock prices. The connection between two currency markets can be used to forecast the pathway their exchange rates will follow. This is an advantage as it will benefit multinational corporations in managing their exposure to foreign contracts and exchange rate risk stabilizing their earnings. Also with regards to investment funding cases currency may well be considered as an asset. In economies where the currency values decrease international investors would be reluctant to hold on to assets as this would grind away their return on investment. For example if the US dollar were to depreciate, foreign investors avoid holding on to US assets together with stock. Furthermore if investors were to sell their held US stock, this would force share prices to decrease due to devaluation of the US currency exchange rate. "The stock market will tend to react ambiguously to currency depreciation". http://org.elon.edu/ipe/dimitrova%20final.pdf

An increased nominal exchange rate in short term is consistent with a decrease to an equilibrium level, which is when the real exchange rate is at its best. A decreased exchange rate indicates a moderate increase in domestic prices due to a rise in imports. As a result the nominal exchange rate is depreciated leading to potential future inflation. This is undesirable for the stock market as it inclines consumer expenditure in goods and services consequently affecting corporate earnings resulting in a decrease towards stock prices.

It has been identified by Ito and Yuko (2004) and Khalid and Kawai(2004) that the association between the stock market and exchange rate currency may well have proliferated the Asian Financial Crisis in 1997. The crisis which began in Thailand where a speculative attack happened on the currency leading to a collapse of the Thai baht is thought to have led to a slump of other economies in the east known as a contagion effect. The breakdown was due to a deficiency of foreign currency to maintain their fixed exchange rate. Factors influencing this crisis include the existence "of fixed or semi-fixed exchange rates in Thailand, Indonesia and South Korea". [http://www.economist.com/node/9432495]

When an exchange rate devalues, the effect on economies will be different according to importation and exportation quantities. Those companies who rely on heavy importation will have an increase in costs if the domestic currency is weaker meaning a decrease in company earnings resulting in low share prices. When it comes to a floating currency, those companies that have hedged effectively against exchange rate fluctuations have their earnings and shares protected.

However this makes the domestic currency cheaper for foreign demand and exports rise as a result. This escalation in domestic output is perceived as a gage of a thriving economy by financiers and can enhance share prices. Generally the relationship between exchange rates and the stock market can be inconclusive because there are both positive and negative factors. However according to Ajayi and Mougoue (1996) it appears as though the negative factors outweigh the positive http://ideas.repec.org/a/bla/jfnres/v19y1996i2p193-207.html.

Add something about the exchange rate parity / interest rate parity

Purchasing power parity

Unemployment and GDP

Gross domestic product is the quantity of goods and services manufactured annually within a country. Okun's law is the connection between unemployment and GDP. The law states, "One percent increase in GDP has in the past been associated with an increase in employment of approximately one million jobs5". GDP intensities are determined by demand and supply therefore a growth in demand equals to a rise in GDP resulting in a rise in share prices.

Where there is a surge in demand, an increase in productivity and employment must be maintained to sustain the level of demand. As a result unemployment has an undesirable influence on GDP because a higher national GDP per capita results in a fall of national unemployment. This results in cost reduction events such as employee redundancies to save on salary expenditure as companies look to preserve money because of a decrease in earnings. As demand of goods and services have fallen, share prices drop as GDP per capita is also on the decrease.

On the other hand when GDP increases and there is more demand for goods and services this reflects on a rise in unemployment levels. Shown in research carried out by Gavin Michael "thriving stock market has a positive effect on cumulative demand" Gavin (1989). When there’s a growth of employment and GDP this tends to be sign that the economy is thriving. Resulting in sentimental values in the form of higher consumer confidence and an increase of goods and services demands. To ensure higher demands are maintained companies need to employ more resulting in a rise of share prices due to more demand and supply.

Conclusion

All macroeconomic variables effect stock market prices in different ways some leading towards a ripple effect on the economy. However the essence of the Samuelson quote is that there is some relationship between the broader economy and stock markets, but it is not a perfect relationship. There may be other forces at work such as investor’s irrationality, market trends and world events that can move the market valuations as well. Investors can predict future outcomes for the economy using macroeconomic variables to some extent but moreover these are just predictions due to the many factors which need to be considered it is difficult to state the exact future of the stock market.