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Economic Conditions Affecting Investment In The Stock Market

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Question:

Write about the Economic Conditions Affecting Investment in the Stock Market.
 
 

Answer:

Investing in the stock market can be a confusing and daunting task for first-time investors. The stock market is a complex market, which involves many fundamental and technical analyses of the market indicators. Securities markets are very volatile and insecure especially to investors who have little knowledge of how it works (Hafer & Hein, 2007). The investor has to consider many factors that may affect how the investment will be to avoid losing capital. A number of factors that will affect the investment decision of a first-time investor. In this essay, we shall discuss the economic factors that affect investment decisions regarding the stock market. According to Petroni et al (2013), the economic factors include interest rates, changes in GDP, inflation, unemployment, and foreign exchange rates.

Interest Rates

This is the most relevant economic factor that affects how investors put their money on stocks. Interest rates are established by the Reserve Bank and individual commercial banks. The rates can have an adverse effect on the stock market because investing in stocks is a form of lending money to the companies (Petroni, et al., 2013). The higher the interest rates, the more expensive it is to borrow money. The increase in the interest rates will lead to the investors requiring higher returns from the stocks since the risk-free rate is now higher. Risk-free investments include investing in government bonds or depositing money in a bank account. This means that the return involved in taking the risk is now higher and higher risk will demand a higher return.

Companies, however, are not in a position to manipulate their returns at any particular short notice. Prices of the stocks may drop due to the increase in interest rates. Keeping all other factors constant, the investors may have to buy the stock if they do not mind taking the additional risk involved. Nevertheless, low prices of stock do not mean that the stocks are undervalued (Hafer & Hein, 2007).

 

Inflation and Deflation

Inflation refers to the rate at which the prices of commodities in an economy increase while deflation is the opposite of inflation involving drops in the costs of commodities. Inflation is caused by changes in the cost of other factors that affect the final price of the commodity. Such factors include costs of manufacturing, transport, and other external factors like the conditions involved in producing the commodity (Abel, et al., 2015).

Inflation can have profound effects on the stock market and will influence investment. Low rates of inflation cause investors to sell intensively while high inflation rates will cause investors to assume that companies are holding back on spending. This cause a reduction in revenue. The high prices of commodities together with less revenue will cause the stock market to drop. The same happens in the case of deflation where investors will view deflation as a sign of a weak economy and hence a drop in the stock market (Petroni, et al., 2013).

Whenever there is an indication of increasing rates of inflation, the Reserve Bank tries to handle the situation by increasing interest rates in trying to syphon the excess liquidity from the system. By doing this, the Reserve Bank hopes to attract investors to put their money in fixed income instruments. In theory, the less liquid the system is, the less the economy will speculate demand for commodities hence the inflation rate will slow down.

Expectations of higher interest rates in the future has a bearish effect on the stock market. Higher interest rates encourage investors to move their cash from stocks to more secure and attractive investments like money market funds. This has the effect of lowering the demand for stocks and hence the prices of shares will as well come down.

In addition, stocks are a good investment during times of high inflation. This is because companies can raise prices to counter the rising costs of commodities due to inflation. For instance, when the cost of production increases due to inflation, companies can easily pass the increased costs to consumers by increasing the prices over time. The increase in prices of the companies’ merchandise means that there is an increase in revenue and earnings. Share prices for these companies will increase as well because of the higher earnings that will lead to a higher valuation.

Therefore, the investor should know and take advantage of the changes in inflation and consider the market falls. Stocks are a good way to hedge against inflation in the long term.

 

Foreign Markets

Economic trends in other markets around the world impact the local stock market of any country. The world is increasingly becoming smaller because of the internet and advances in communication. This also applies to the financial markets as geographical boundaries are now meaningless and there is an easy flow of information and economic data around the world.

A country’s stock market may represent a chunk of the country’s economy (the country’s companies operating within the country and employing the citizens of that country). However, this stock market is faced by a big influence from the rest of the world especially from the performing giants like the US, Japan, China and Australia. The activities in these big economies can have a big sway over the market than that caused by the domestic companies and economic data.

When the foreign market is facing difficulty, the domestic companies will not be able to sell as much as their potential can allow. This fall in sales causes, a drop in revenue and these will heavily influence the stock market of any particular economy. Therefore, the investor needs to consider the activities and trends that the international market is taking before investing.

 

Economic Growth Rates

Whenever economic growth rates of an economy are mentioned, it often revolves around the GDP. GDP is the total monetary value of economic goods and services produced by an economy over a certain fixed period (Mankiw, 2007). A higher GDP indicates more economic activity and higher growth figures indicates that the economy is healthy and this may lead to better investments because of the expectations that there will be better stocks return. The basis of this theory is that the GDP of an economy is made up of a combination of its consumption, investment, government spending and its exports less the imports (Mankiw, 2007). Any increase in any of these factors is expected to have a positive effect on the sales of companies. Better sales for companies means there will more be earnings recorded and this will translate to higher returns in the stock market. The opposite of this also holds.

However, this is not usually the case because the figures do not have a direct relationship. GDP figures are usually from the past to the present while equities are forward-looking. That is, the investors tend to value stocks in terms of its current value and the returns that it will fetch in the future. Nevertheless, this does not mean that there is no relationship between economic growth and investment. Companies require a healthy economy for them to perform well. An economy that is performing badly will provide low profits for companies. This, in turn, will mean lower stock prices for some of the firms.

Comparison of the GDP growth of different economies can help the investor to make a decision whether to invest in domestic or foreign markets. Most investors will buy stocks of companies that operate in rapidly growing economies (Hafer & Hein, 2007). Therefore, an investor needs to consider the future performance of an economy in making investment decisions. The investor should consider how the GDP is growing to see how the economy is changing so that he can be able to allocate his assets efficiently.

 

Unemployment

Similar to the GDP, unemployment rates show how developed and strong an economy is. It indicates the amount of people in the economy who are responsible for the production of the GDP of the economy. The government policy makers and economists use unemployment rates to determine the current state of the economy and predict the future levels of productive activity in the economy.

Investors also ought to follow the figures closely and digest potential changes in them because they are critical to an economy’s health (Petroni, et al., 2013). The relationship between unemployment rates and activity in the stock market is quite straightforward. Lower rates of unemployment indicate more economic activity in the consumers market and hence more revenues for the corporations. More people in employment will ensure a high economic output, increased retail sales, more savings and more profits for the companies. As a result, the stock market always rises or falls depending on the reports on employment.

All the factors that we have discussed above have an impact on how an investor will make decisions concerning the stock market. it may not be wise for the investor to make decisions basing on a single factor. This is because, as we can see from the above explanations, most factors are interrelated.

In addition, latest data and figures on the GDP, inflation, and unemployment are usually backdated and refer to the past. They do not indicate the current situation in the market while investment is about speculating about the future trends in the market. Past data may not provide these trends but the investor will need them to consider the economic conditions and how the conditions will affect the returns in the future. This way the investor can make decisions that are more informed.

 

References

ABEL, A. B., BERNANKE, B., & CROUSHORE, D. D. (2015). Macroeconomics.

ALTAY, E. (2003). The effect of macroeconomic factors on asset returns: a comparative analysis of the German and the Turkish stock markets in an APT framework. Halle (Saale), Univ., Wirtschaftswiss. Fak.

BERNSTEIN, J., & BERNSTEIN, E. R. (2002). Stock market strategies that work. New York, McGraw-Hill. https://public.eblib.com/choice/publicfullrecord.aspx?p=4654781.

BIGGS, B. (2014). Biggs on finance, economics, and the stock market: Barton's market chrinicles from the Morgan Stanley years. Hoboken, New Jersey, John Wiley & Sons.

FONTANILLS, G., & GENTILE, T. (2001). The stock market course. New York, Wiley. https://public.eblib.com/choice/publicfullrecord.aspx?p=117689.

GA?RTNER, M. (2016). Macroeconomics. Harlow, Pearson Education.

HAFER, R. W., & HEIN, S. E. (2011). The stock market. Westport, Conn, Greenwood Press. https://www.credoreference.com/book/abcstockmarket.

HART, C. M. (2005). I want to make money in the stock market: a step-by-step process you can follow to enter the fascinating world of stock market investing : learn to begin investing without losing your life savings. Denver, CO, Outskirts Press. https://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=249446.

KRIER, D. (2005). Speculative management: stock market power and corporate change. Albany, State University of New York Press. https://public.eblib.com/choice/publicfullrecord.aspx?p=3407701.

O?ZC?AM, M. (1997). An analysis of the macroeconomic factors that determine stock returns in Turkey. Ankara, Sermaye Piyasas? Kurulu.

PETRONI, F., PRATTICO, F., & D'AMICO, G. (2013). Stock markets: emergence, macroeconomic factors and recent developments. https://public.eblib.com/choice/publicfullrecord.aspx?p=3023206.

TSIAPLIAS, S. (2007). The macroeconomic content of equity market factors. [Parkville, Vic.], Melbourne Institute of Applied Economic and Social Research.

VINOD, H. D., & REAGLE, D. P. (2005). Preparing for the worst: incorporating downside risk in stock market investments. [Hoboken, N.J.], Wiley-Interscience. https://www.123library.org/book_details/?id=7047.

YARTEY, C. A. (2008). The determinants of stock market development in emerging economies: is South Africa different? Washington, D.C., International Monetary Fund, African Dept. https://catalog.hathitrust.org/api/volumes/oclc/213815732.html.

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