Stock Market

A country’s stock market weighs a great deal in the prosperity and development of the macroeconomic environment. The price of securities is closely linked to economic development, and both investors and securities are affected by economic variables, such as national financial performance, the adjustment of exchange rates and interest rates. Stock prices follow a downward trend during an economic recession and grow during an economic recovery. Understanding the stock price index is a fundamental part of investment analysis and impacts on the decisions of investors. An examination of price fluctuation and economic variables helps investors to predict the stock market movements of firms or industries, and whether there is potential for profitable investment. Macroeconomic change is a significant factor that influences stock price trend, and provides information to investors that enables them to make money by trading stock. This paper will focus on the influences of macroeconomic variables on performance of stock. The effects will be assessed by examining five different factors, which are: GDP, inflation, interest rate, money supply and exchange rate.

Gross domestic product (GDP) can be defined as the value of the entire output of goods and services in a country. It is calculated through three variables, which are: income, spending and output. GDP is an aggregate indicator that reflects the economic strength and development of a nation, and also has a significant impact on the stock market. Stock prices are closely linked to the performance of stock issue companies. If GDP rises, it means the economy is performing well and overall financial prospects are positive. As a result, companies will increase investment, which in turn will increase and create higher stock prices. In contrast, a decrease in GDP leads to companies reducing investment due to a lack of confidence in the market and lower expectations (Kwon, Shin and Bacon, 1997). Consequently, an increase in GDP has a positive impact on the economy and share prices, and encourages investment and consumption. However, if demand exceeds supply, inflation will increase. In this scenario, governments can strengthen macroeconomic controls, for example by altering interest rates, which will affect GDP and have a negative impact on stock prices (Chandra 2004). Liu, Hsu and Younis (2008) suggest that fluctuations in the stock market are consistent with movement in a macro economy. Business cycles include four different stages: recession, crisis, recovery and boom, and the stock market reacts to these factors through shifts in price. Although GDP and share price are positively related, the stock market is independent and influenced by many variables.

Money supply is the entire sum of finances in circulation in a national economy. This includes cash, coins and money held in saving or checking accounts. Hamburger and Kochin (1972) suggested that money supply and stock prices has a positively correlation, which means that increasing money supply will push share prices up, whilst reducing money supply will push the value down. According to Ibrahim (1999), changes to money supply levels impact on the expectancy of investors. This effect occurs when the central bank implement an expansionary monetary policy, which affects the funding supply and influences stock prices. If the money supply increases, stock values also rise (Ozyaster, 2004). Since the rate of borrowing is low, consumers are encouraged to borrow more money from banks or financial lenders. In turn, goods and services become more affordable, so the consumption of both necessities and luxuries increases. This increases companies’ profits and pushes the price of stock up. In addition, more people consider investing money in the stock market to boost their portfolio because they have a greater amount of disposable income, which again leads to higher stock prices. In contrast, an increase in saving reduces the money supply, which has a negative effect on share prices. Mukherjee and Naka (1995) present an alternative opinion, suggesting that a rise in money supply has a negative influence on stock. Due to the positive correlation between rate of inflation and money growth (Fama, 1982), a high level of money supply increases the discount rate. This has a damaging impact; however, it can be relieved  by the economic stimulation of money growth. The stimulus is a company earning effect, likely to lead to a rise in cash flow and security prices.

The interest rate is charged to the borrower, and is expressed as the annual proportion of a loan. It is one of the key factors that affects the stock market. According to Saborowski and Weber (2013), interest rate is the cost that a bank or lender has to pay to the central bank in order to borrow money. Controlling interest rates is a way of adjusting money supply. When the central bank sets the interest rate, it will affect both individuals and businesses. Individuals will receive less revenue from their savings so they are more likely to invest in financial securities. This, in combination with higher cash flow and company discount rates will increase the value of shares. For companies, it will be difficult and more costly to borrow money from bank. Consequently, a corporation’s profits will decrease, which in turn affects the price that stock market participants are willing to pay (Nozar and Taylor, 1988). Stock prices are affected by the relationship between supply and demand. If the interest rate rises, stock transactions will be more costly; however, investors have high requirements regarding rate of return, and so if the supply exceeds demand, the price of shares will drop (Mukherjee and Naka, 1995). Furthermore, a higher interest rate means people achieve greater revenue from bonds. This makes bonds more attractive to investors. They will sell stock and buy bonds, which will bring a negative impact to the stock market.

Inflation refers to an increase in the price of goods and services which leads to a decrease in the purchasing value of money. In order to maintain a strong and prosperous economy, the central bank has to avoid significant plunges in inflation. Inflation has an important effect on the stock market and also influences other macroeconomic variables. During a period of inflation, currency devaluation encourages people to exchange goods that hold their value. Stock is one hedging instrument, and so the demand for stock will increase and the prices will rise. Fama and Gibbons (1982), however, suggests that inflation has a negative impact on stock prices. Governments typically implement a tight monetary policy to limit inflation, which will cause the increase of the risk-free rate as well as the discount rate (Maysami, Howe and Hamzah, 2004). Investors willing to sell their stocks, plus a fall in the demand for stocks, will see share prices drop. That means the relationship between inflation and share price is uncertain. Panetta (2002) examines that the link between inflation and stock prices is dependent on a different factor. There are two types of inflation: expected inflation and unexpected inflation. The former occurs when demand exceeds supply; the latter when supply exceeds demand. When inflation is predicted, governments will increase purchase prices to stimulate supply. Firms can make more money by increasing costs, which leads to increased spending in dividend. This is explained by the formula for stock prices under a dividend discount valuation model: P=D /(k-g)