5 Ways How Economy Impacts Stock Markets

Summary

• Economic indicators foreshadow many stock market trends which prompt investors to keep a tab on them.
• Economic indicators do not give a full foresight into stock market trends but can be used to avoid a shock-like scenario.
• The relationship between stock markets and the economy is two-way as there are many economic impacts of fluctuations in the stock market.

Stock market investors often make it a habit to keep track of changing economic trends. Economic indicators often foreshadow many of the stock market trends. While it may not be possible to predict the stock market developments at every step, economic indicators can be a significant determinant in building or breaking investor confidence.

For example, a report by Moody’s Analytics revealed that total global debt climbed by $24 trillion representing a new-high of 366% of gross domestic product in 2020. Chief APAC economist of Moody’s Analytics, Steve Cochrane said “the debt loads rose most in emerging markets and they may have the most difficulty in terms of taking care of this debt going forward. ” This indicates that economic recovery  in emerging markets will be slow compared to developed markets because of higher debt levels, thus affecting overall investor sentiments.

Interestingly, the relationship held between the economy and the stock market goes both ways. Changes in the economy make the stock markets volatile, and it is this volatility that investors find themselves profiting against.

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Here are five ways in which the economy affects the stock markets:

Interest Rates

Monetary policy is a robust government intervention tool used to keep economic factors in check. Interest rate changes taken up in a monetary policy affect the stock markets in two ways. Firstly, when interest rates are increased, a premise for reduced borrowing is set. Such a scenario makes loans costlier as the interest amount to be repaid on a loan increases. High interest rates tend to withdraw liquidity out of the economy, making it hard for businesses to service debt. This could be potentially detrimental to the profit earned by companies as they would not be able to carry out debt financing. Consequently, investors expect that it would hurt the stock market badly.

On the other hand, if interest rates are reduced, companies find it cheaper to finance their operations using debt. This generally marks an upswing in stock market activity as companies bring in profits.

Secondly, interest rates affect equities indirectly through the bond market. As interest rates are lowered, bondholders derive reduced interest income. Thus, they shift to equities instead. The influx of new capital stirs up the stock market further.

Inflation

Inflation serves as a key economic indicator for multiple reasons. While an increase in inflation may not always be an alarming situation, policymakers keep a watchful eye on the macroeconomic indicator. High inflationary pressures can have an adverse effect on the stock market.

For businesses, high inflation is an indication of rising capital costs. This means a loss in profits as inflation eats away the real value of money. Even inflation expectations cause adverse changes to the stock market as investors start withdrawing their money from equities. It has been seen through past data that most stock market indices do not react positively to rising signs of inflation. Stock market indices like Dow Jones Industrial Average (DJIA), S&P 500 and S&P 200 have recorded a decline on inflationary scenario. Indices that involve a lesser number of companies are more sensitive to inflationary pressures compared to broader indices that cover companies from different industries.

Additionally, growth stocks are hurt under inflationary pressures due to their future returns being diluted due to inflation. Value stocks, which offer roughly the same amount of returns in every period, become investors’ go-to assets.

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Exchange Rates

Exchange rate fluctuations can largely affect the profits earned by firms having overseas operations. These firms usually earn profits in a foreign currency, which is then converted into the local currency. If the domestic currency loses value against the trading partner’s currency, then the profits earned overseas are washed away when converted into local currency.

Additionally, a currency appreciation makes domestic goods appear more expensive than foreign goods. This reduces the demand for domestic goods in foreign countries. Additionally, foreign investors are scared to put investments into domestic projects. This hurts the profitability of firms as their overseas revenues drop. Thus, the stock market performance is affected when the whole industry suffers due to lowered revenues.

Gross Domestic Product (GDP)

The Gross Domestic Product represents the total market value of all goods and services produced in a country. GDP provides a microscopic view of the economy’s health as it includes various aspects encompassing the economy.

High GDP levels are generally taken as good news by investors. GDP growth is a sign of increased economic activity and increased output. This increased profit raises investor confidence which makes room for increased stock market activity. Conversely, a drop in GDP is a sign that companies may struggle to keep their profits afloat. This discourages investors from participating in the stock market.

This decreased stock market confidence can then translate into lower economic growth. Thus, a cycle can perpetuate, leading to further drops in GDP and, consequently, to subdues stock market performance.

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Unemployment

Unemployment rates are essential economic indicators for the government. Economies with low unemployment rates are expected to have high levels of production. This, in turn, points to strong financial performance of firms and better stock market returns for investors.

However, high unemployment is not a good sign for the economy as well as for investors. High levels of unemployment mean surplus workers in the economy than companies can hire. Less working capacity and an increased unemployed population are linked with lower productivity. As firms start to incur losses, their stock market performance is affected. Therefore, investors lose their interests in equities and withdraw from the market.

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