Understand the Linkages between Economics and the Equity Market


We come across a number of updates on the stock markets and economies across the globe each day and often find a correlation between the performance of the two.

For instance, optimistic trade surplus data led to a surge in the S&P/ASX 200 index on 9th January 2020.

It is being said that to become a successful stock investor, one should have a working knowledge of the basic economics. This helps investors filter financial news and identify relevant information to make better investment decisions.

Understanding of economics can offer investors with the tools to forecast macroeconomic situations and understand the nuances of those projections on stocks, businesses and financial markets. Moreover, economics can assist investors in understanding the possible impact of a country’s policy and events on corporate conditions.

By applying macroeconomics in tracking inflation, deficits and GDP, investors can make more informed investment decisions. On the other hand, microeconomics can help an investor identify a reason for variation in the stock price of a particular company.

Let us now try to understand the economic factors that affect the stock market:

How Economic Indicators Affect Stock Market?

Though its not possible to entirely predict the performance of the stock market, investors can keep a watch on economic indicators to get an idea of the market outlook. It has been observed that positive changes in an economy support majority of the companies, particularly those who rely on the good economic environment.

Take a look at some of the economic factors that cause movement in stock prices:

Economic Growth: The economic growth is a leading indicator of an economy’s health, which enable companies to feel more confident of their financial position and investors have more trust in the equity market.

A higher economic growth signifies better prospects for the company’s growth, which can boost their share prices further. However, a poor economic outlook usually makes investor more selective about the stocks they hold.

Interest Rates: Generally, a lower level of interest rates in an economy makes stocks more attractive as people find it less beneficial to save money in a bank or hold bonds. In the reverse case, the stock market goes down when interest rates move up.

Moreover, the stock market movements are much higher on expectations of a rise or fall in interest rates. Investors usually prefer to sell off stocks when there is an expectation of an interest rate hike in the future.

Inflation/Deflation: Inflation and deflation vary the level of consumer spending in an economy. Inflation usually causes a decline in the company’s sales and profits, thereby leading to decreased economic activity. The central bank increases/decreases the interest rates in case of inflation/deflation, resulting in weak/better performance of the stock market.

In addition to these key factors, some other economic indicators including exchange rates, unemployment, retail turnover, etc also impact the stock market.

There has been sufficient historical evidence that shows economic variables are one of the key causes of stock market performance.

US Housing Market Downturn Led to Stock Market Crash in 2007-08

The global banking systems and financial markets experienced a period of extreme stress between mid-2007 and early-2009 due to the US housing market downturn that spread from the US to the rest of the world via linkages in the global financial system.

In addition to a number of bank failures around the world, the value of equities (stock) and commodities declined considerably across the world.

Slowing GDP Growth Resulted in Stock Market Selloff in China in 2015-16

The stock market bubble busted in 2015-16 in China as investors lost confidence in the market amid slowing GDP growth and falling petroleum prices. The stock market crash was so large that one-third of the value of domestic shares was lost within one month from mid-June 2015 on the Shanghai Stock Exchange.

The losses in the stock market led to the decline in the value of stock prices across the globe. The period of the 2015-16 stock market downturn is referred to as The Great Fall of China.

In addition to the economic indicators, political and geopolitical risks also stimulate variations in the stock exchanges. For instance, easing geopolitical concerns between the US and Iran and stronger retail sales figures powered ASX to a record high level on 10th January 2020.

The benchmark S&P/ASX 200 index closed the trading session at 6929 points on 10th January 2020, with a significant rise of 0.8 per cent or 54.8 points.

Does the Equity Market Also Impact the Economy?

Yes, the reverse is also true. The stock market can also have a deep impact on the economy via consumer and business confidence.

In a bull market, when the share prices are rising or are anticipated to rise, a great deal of optimism is created around the economy. Rising stock markets encourage corporations to launch new products, raise capital to pay off debt and expand operations. All these activities usually lead to a boost in GDP of a country.

Moreover, bull markets result in a wealth effect as people gain confidence of a rise in the value of their investment portfolios. This leads to increased consumer spending, resulting in higher GDP.

On the other hand, the collapse in share prices can trigger widespread economic disruption. For instance, the stock market crash of 1929 contributed to a great depression of the 1930s.

Sector Rotation Investment Strategy Can Help You!

Now when we know that the economy and stock market influence each other to a great extent, the question arises that how can we tap the potential gains in the equity market amidst considerable volatility in the economic environment?

Sector rotation investment strategy can primarily help you out. It is an investment strategy that involves a movement of funds from one sector of the economy to the other to deal with the market fluctuations. In this type of strategy, an investor can use the funds from the sale of securities associated with a particular sector to buy securities in the other sector. The strategy helps investors capture significant returns over a period of time by diversifying holdings.

To take the most advantage out of this investment strategy, investors can begin to move ahead of time into those sectors of the economy that likely to outperform as the stock market is forward-looking.

In a nutshell, it is beneficial for an investor to perform an in-depth analysis of economy’s health before making a stock selection. The examination of economic trends provides a better idea of the stock market's health, increasing the likelihood of enormous returns.


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