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How to Macroeconomy affects the stock market

At the End of February 2021, the US Bond yield increased at 15 basis points, After came out this news to the stock market as soon as the Indian stock market tumbled over 5 percent. Why Bond yields adversely impact the Indian stock market and also all emerging markets.

Generally, the stock market is a mirror of economic health. Whether it may be positive or negative Macroeconomy indicators such as inflation, exchange rate fluctuation, interest rate cycle, corporate earning power, monetary policy, and business confidence.

We are going to discuss in this article how macro indicators impact the stock market. Macroeconomy indicators would give an earlier signal, the stock market cycle is going to change very soon.

Here I have given Macroeconomy indicators that help to predict the stock market direction and would bring the idea of how to price changes in the stock market.

Central bank’s Monetary policy.

Inflation

Interest rate

Exchange rate

GDP growth rate

Index of industrial production

Monsoon data

Economic uncertain

Reserve bank of India’s Monetary policy

Reserve bank of India’s primary function would monitor the essential goods prices, foreign exchange rate, and ensuring credit flow in productive sectors. Every two months, the RBI Monetary policy committee discusses the current economic scenario and would take relevant action for the smooth function of economic activities.

Money flow

Normally, massive money flow will boost the business activities, create purchasing power following that more demand would attract more investment. RBI has lots of monetary tools to improve and control the money flow. Such important tools are Repo Rate, reverse repo Rate, and Cash reserve ratio.

Higher money would lead to rises in the price. As a result, inflation.

A lower money flow would lead to lower consumption and business entities get struggle to generate funds for their business operation.

Higher money flow would increase the production costs. Business firm’s net profit will decrease, for that reason business firms tend to reduce their investment by lack of consumer demand and low profits.

Lower money flow would increase the unemployment rate, severely affect the country’s GDP growth rate.

As I saw earlier, how to money flow plays a key role in economic activity. When inflation moves to an uncontrol level the RBI Monetary policy committee tends to keep under control inflation. During 2011, all commodity goods had been skyrocketing by supply-side demand and currency between many developed countries. Followed that our INR had been depreciating tremendously so RBI increased interest rates at so many times to prevent further fall of currency. As a result, the dried money flow.

During that time Indian stock market was traded in undervaluation, though, Investors did not show any interest to buy equity because of higher interest rates so investors had parked their money into the credit market.

As well as, 2008 Laymen Brothers bankruptcy news was made shocking waves across the world market. All financial markets were sliding down by financial instability. Thus, RBI tightened the policy to protect the currency depreciation and higher inflation. After the end of 2008, RBI started to reduce interest rates to improve liquidity even though escalating the tension about recession.

RBI monetary policy

Generally, RBI would use three key tools to improve liquidity and also reduce liquidity according to the economic situation. every Bi-monthly RBI would announce their monetary policy about rate changes of Repo rate, Reverse repo rate, and CRR. We will see a brief definition of monetary policy roles in the money-market and the stock market.

Repo rate

Repo rate is a short-term lending rate, the commercial banks typically borrow money from RBI when they face fund scarcity. The RBI lending loans to banks, which loans the interest-bearing, if RBI increases this the interest rates banks will have to repay more interest.

as well as if the central bank reduced this rate. With being lower interest rate, banks would provide more loans to lenders. A higher money flow leads to more spending and product demand. so lower interest costs will stimulate the aggregate economy. These rate changes are commonly measured by basis point instead of percentage. Current repo rate 5.15% as of Feb 2021.

Reverse repo Rate

It is the same opposites to the Repo rate. If RBI decided to control money flow Reverse repo rate will be hiked. The central bank borrows money from commercial banks, RBI would give interest to banks.so, banks would deposit excess money in RBI for additional interest income Which action would reduce the outflow of money from the banks. Current Repo Rate 4.90% as of Feb 2021

Cash reserve ratio

Indian banking & financial industry are regulated by RBI. To ensure customer protection or perhaps, the banks are not able to meet the financial crisis. So, RBI would retain a certain amount of money themselves. All banks are compulsory must deposit a certain percentage of the money in RBI which is called that the statutory liquidity Ratios (SLR), cash reserve Ratio (CRR). When increasing the inflation or exchange rate depreciation RBI will hike this rate, then banks will have to park more money in RBI. RBI would not provide interest to CRR.

During the Recession or sliding GDP growth RBI will reduce CRR due to improve the liquidity and stimulate consumer demand.

Impact on the stock market

The RBI decision is a more crucial thing to the stock market because liquidity will determine the GDP growth and private consumption. Everyone stock market participant will be closely watching the RBI decision. reduction of Interest rate announcements always could be surprised to the stock market which put hold the bull market otherwise the stock market will rebound from the lower level. If it is being into the bottom level.

Above this graph meant to interest rate cycle normally establish optimism when interest comes- down, as well as, create pessimism when the interest cycle moves upward. Upward interest rate cycle would lead to the bear market. On other hand, a downward interest rate cycle would create a bull market. Higher interest rates encourage investors to do invest in a risk-free investment.

The Monetary policy rate changes impact some sectors especially cyclical sectors such as Automobile, Real estate, and construction. The central bank starts to reduce the interest rates almost cyclical sectors will get more benefits. On the contrary, the higher interest-rate would hurt the cyclical stocks.

Inflation

The Stock market hates inflation. However, inflation depreciates the currency value and asset value. Extreme level inflation indicates that the economy is in more heat. Moreover, essential goods and commodity price raises could make an impact on the common man and firms. in this critical situation, The RBI has to be intervention to control the higher inflation. Then the business cycle will turn negative path.

Inflation is unavoidable, India’s moderate inflation range between 4-6. If inflation exceeded this level, a panic situation will spread amongst the investors.

How to inflation affect stock prices?

Higher input costs and increases of the financial costs would affect the company’s sales and profit especially the operating margin will hurt. Therefore, equity investor’s investment returns might affect by inflation.

A country needs to reach stable growth, and fast economic growth- the country should maintain the stability of the currency valuation, more fluctuation of exchange could be more-risk to foreign investors when converting in dollar terms, the return on investment could shribk.

high inflation, plenty of money exit from the stock market, which factors depreciate the domestic currency value. So when foreign portfolio investor’s investment value would shrink by lowering the domestic currency value, they tend to get back their money from India.

Individual investors and mutual fund investors would divert their investment to risk-free investment. If the stock market is anticipating, RBI could tighten monetary policy in the coming policy meeting. Following that The Banks also would increase the deposit rate for their upfront financial requirements.

High inflation leads to low liquidity and uncertainty of the economy.

Which sectors could do well and worst during high inflation?

Some industries are very interest-sensitive. Like Automobile, real estate, construction, and metal sectors. These sectors are having interconnected between them. Probably 60 percent of the consumers are purchasing products through monthly installments (EMI). Interest rates play a key role- consumers when take purchasing decisions. If increase financial cost they would postpone their purchasing decision. When it occurring low-interest-rate- affordable financial costs motivate the buyers to buy more products. So that, interest rate changes seriously watching by the stock market. More likely, cyclical stocks will hurt by inflation, as well as, which cyclical stocks will outperformance during the low-interest period.

As I pointed out earlier, inflation’s ups and downs would impact the exchange rates. India’s IT and pharma sectors are largely depending on export revenue. When the Indian currency will depreciate both industries will get benefits. But overall market sentiment might weaken by the increase of inflation.

Types of Inflation

Inflation has classified into three types. Each type of inflation would make different types of causes in the economy. Which types are Demand-pull inflation, cost-push inflation, and wage Inflation.

Demand-pull inflation

More money when chases the few goods define demand-pull inflation. A country while reaching higher growth sometimes which will make an opposite reaction in the economy. Suppose People if who are spending more money usually, and purchasing more goods intensively, as a result, asset prices would go up day by day. Then become economy got to more heat

These economic-activities stimulate all goods and service prices. Further Demand-pull inflation stimulates the price, on the other side it will good for economic health. High growth and high consumption both of these factors did not suffer economics much more. However, RBI will take mild action against demand-pull inflation.

Cost-push inflation

Indeed, It is dangerous to the economy, financial market concern about cost-push inflation. Essential commodities such as crude oil, base metal, and other ingredients. Which prices when suddenly spike in the international market which reflects in manufacturing and freight costs. Higher costs will pulldown the consumption demand. Moreover, govt has to be spent more dollars importing crude oil and natural gas. As a result, the current account deficit will widen further.

During 2012, in the international market crude oil and coal prices hike hugely stimulated the cost-push inflation in India.

1974 and 2007 also severely affected by cost-push Inflation.

Cost-push inflation would wipe-out the operating margin of companies and dramatically increase investment costs.

The Exchange rate could go to free-fall mode. RBI will have to face a double whammy, RBI got to struggle to balance the economic growth and to control inflation.

Wage inflation

When common people are struggling to fulfill their basic needs, thus who request wage increment. Wage increment will cause wage inflation, typically which will pursue after the demand-pull inflation. Unlikely India not to be suffered by this inflation like developed countries, because India is having large pool employee exposure. Normally, Indian companies are providing low wages compare with developed countries.

During the high inflation, the stock market had faced the bear market, as well as, low inflation leads to the bull market.

GDP Growth data

India is one of the fastest-growing economies in the world. Since after, economic reforms India has achieved tremendous growth. GDP rate is calculated by overall economic and business activities.

The service sector, manufacturing sector, the agricultural are contributing to aggregate growth. between 2003 and 2007 and 2013-2017 had been reached higher growth. in terms of purchasing power parity (PPP), Indian is in 3rd placed. Now, India is 3rd largest economy in Asia, 2nd largest economy on a PPP basis. As well as, 5th largest economic power in the world,3rd largest economy on a PPP basis.

In 2030, India will be the third largest economy in a value basis. 2019 Coronavirus outbreak largely affected on economic growth, in Q1 FY20 India’s economic growth downturn -24% of the historic low as well as 1988-1989 India had gotten 10.2% recorded growth since ever. After 1991, as long as India has been attracting abundant foreign direct investment.

Swot analysis of India’s GDP growth

Strength

Great workforce

Large English- speaking population

Stable economic growth, mostly, the Indian economy is not affected by external factors.

Huge consumption demand

Weakness

Inadequate infrastructure

One-fourth of people living under the poverty line.

Low productivity

High unemployment.

Inequality current socio-economic condition.

Overview of economy

According to the2019 data, India’s Gross domestic value was 2.87 trillion US Dollars. In 2006 India reached-out to 1 trillion economies. Most of the study revealed that India’s economic growth could be more- faster after 2022, After covid 19 effects, the Indian govt had announced around 20 lacks stimulus package. After that, the economy recovered faster rather than in other countries. One month back IMF released that India would achieve 11% growth in FY 21-22. Before that many economic analysts expected that the Indian economy would get 8% growth, but IMF projection is higher than earlier estimated.

Right now, the stock market participants are betting for higher growth despite benchmark index Nifty P/E trading at a historic high.

How to impact GDP data on the stock market

The stock market participants must need to understand the basic sentiments of the stock market. The stock market is not pricing for the current event market is priced by expectation basis. So that, Dalal street is spending few thousand crores every year.

Indian stock market average return is 14%. It is relatively very high than developed nations. US and European investors are coming towards the Emerging countries stock market.

High GDP growth helps to business expansion and new investment. During the rapid growth period, Indian corporate’s sales and profit would increase dramatically. Expectations of rapid growth would make a positive into the stock market.

During the recession period, the stock market would punish the stock market mercilessly, the stock market experts would predict earlier upcoming recession through some signs.

Earlier sign of recession

The Recession is a significant decline in growth. recession is visible in Unemployment, the decline in production and consumption, and real income. Sometimes it spread across a certain territory or the rest of the world. The global economy has been long-term growth, the short-term fluctuation of economic and many economic indicators show negative bias. The short-term economic growth suffered by various factors, which economic decline may sustain at six months or up to a few years.

The policymakers would take lots of actions to recover the economy. Typically, recession follows the end of the economic expansion, each business cycle has brought economic expansion in a long-term growth trend. While the economy at reach stagnation, the recession would start.

1991, 2000, 2009, and 2020 are good examples of recession.

In this situation, govt tends to infuse more liquidity into the system, to bring back to normal situation. Moreover, Monetary policy keeps a lower interest rate to avoid a credit crunch.

Few key indicators would show earlier signs would the arrival of recession.

Unemployment, liquidity deterioration, inflationary pressure, and slow down economic growth.

Recession is one part of the business cycle, the end of each business cycle leads to technology transformation, structural changes, and new industries come-up with modern business models.

Business cycle

Business cycles consist of recession, business expansion, and peak. Economic expansion and contraction – recession start at the peak of the business cycle. It is also known as the economic cycle. Every new business cycle push-up the top one new industry.

Above this depict tell us to every peak and trough would follow each other. Which is a basic principle of the business cycle. Generally, the Business cycle is like a roller-coaster. The Business cycle which is classified has 4 phases. Those are expansion, peak, recession, and trough.

During the expansion phase, economic growth turns to the high-growth path. Low Unemployment, strong consumer demand, and business would utilize the production capacity. The central bank will sustain low interest-rate, businesses would expand their business according to pick-up demand.

During the peak phase, the economy would get more heat. Basic commodity prices shoot-up by higher demand, inflation will follow by the basic material price hike. Then, RBI will have to take some measurements against inflation. The Interest rate will turn-up again. As a result, the economy gets slow-down.

During the recession phase, the RBI would consistently increase interest rates to control the money flow to cool-off the economic over-heat. Perhaps, if this monetary policy action will not reduce inflation or economic activities will purse like a peak level that means the economy will fall-down in recession.

During the trough phase, the economic activities always could go to a stagnant level. higher interest rates, sluggish demand, and poor corporate sales are leads to de-growth. in this stage, The RBI starts to reduce the interest rate and infuse more money flow into systems.

The business cycle probably, established by interest rate changes. The economy while reach-out the peak level. The central bank has to be intervention to the cool-off over-heat economy. Unless it leads to depression or vulnerably affects the domestic currency value. To control money flow and consumer demand the central bank will increase the interest rate. Let’s see how does interest rate affects the stock market.

As I mentioned earlier about the interest rate cycle, but we need more clarification to understand complicate interest rate cycle.

INTEREST RATE CYCLE

Lower interest rates establish more demand due to cheaper lending costs. Big-ticket items house, car, and items of furniture would be largely consumed as well as consumer cut-off their expenditure when occurring in additional borrowing costs. For instance, in 2006-2007 FY the RBI had been raising the interest rate frequently to control inflation. In the contrast, the RBI had been reducing the interest rates in 2009- 2010 FY due to the Global recession

During the recession, the RBI would reduce the interest rate to recover the economy from a recession.

During the expansionary phase, The RBI would sustain the low-interest rate to attain high-growth.

During the peak phase, the RBI would start to raise the interest rates to control inflation and the economic bubble.

During the economic contraction phase, The RBI would sustain the higher-interest rates by inflation fear.

Relationship of Bond-yield and interest rate

Bond-yield and interest rates cycle both are a close relationship between them. The credit bond is less risky than equity. Bondholders would get an interest amount.

Normally, Govt treasury bonds are given low-interest compare with corporate bonds. Compare bonds are relatively high-risk rather than Govt bonds.

When becoming an increase in the interest rates bond price would fall, Bond-yield would increase.

As well as the bond price would raise, bond-yield will fall when increasing the interest rates.

Now, some doubts come to our mind, what is the bond-yield then how to calculate bond yield?

For that, we must know the basics of the bond price, coupon rate, and bond-yield.

Par value: which is the bond price

Coupon rate: percentage of interest per annum.

Bond-yield: how much percentage interest is earning from par value.

If bond price fall, bond-yield will raise

If the bond price would raise, the bond-yield will increase.

If the bondholders anticipate that the inflation may increase in the upcoming month- The bond price will fall as well as bond-yield will increase.

If the bond market anticipates that the inflation may decrease in the upcoming month- the bond price would decline as well as bond-yield will increase.

So, bond-yield will tell forthcoming interest rate changes.

Types of bond-yield shapes

Most likely, the Bond yield shapes would provide early signs before the arrival of the recession and peak. Which are categorized into four shapes. Of those are, normal curve, steep curve, inverse curve, and flat curve. The First two shapes lead to the bull-market, usually which happens in the economic recovery and expansionary stage. The last two shapes lead to the bear-market.

Normal curve

The normal yield curve defines the halcyon time in the interest rate cycle when the bond market investors expect the economy to continue to expand at a healthy rate without fear of inflation. Such a normal yield curve observed the middle bull expansionary period of the business and the early to the middle phase of the stock market cycle. this is the time RBI would hold the steady interest rate and there is little or no fear of inflation.

It is such times that the market trend is up and specific interest rate-sensitive sectors like Auto, construction, banking, and financial stocks are performing well. Interest rates spread between the long and short end of the curve of several hundred points.

Above this chat is meant to the left side curve signifies the short-term maturity yield curve, the right curve signifies the long-term yield curve. The short-term bond yield is lower than the long-term yield, lower short-term yield defines the economic recovery or expansionary phase.

The steep yield curve

We often observe a steep yield curve are at the start of an economic expansion. just after a recession ends. Such a steep yield curve often argues a major change in the stock market trend and the onset of a new bull market.

At such a point, interest rate low and recovery on the horizon business will begin to engage in new capital investment. This increased capital demand will be financed largely by the corporation taking on more long-term debt.

Drive the long end of the yield curve up in anticipation of expansion. this happens even as the RBI is holding the interest rate steady.

The inverted yield curve

The inverse yield curve comes from interrelated bearish forces. At the short end curve crosses above the long end curve, the RBI began to raise interest rates to fight inflation.

This alone can drive the short end of the curve higher than the long end and invert the curve – even if the long end stays at the same level. this indicates inflation fears influence the capital market. The bondholders are anticipating that more interest rate hikes will happen in the future.

Generally, the inverted yield curve is considered as the economic slow-down or earlier signs of recession. In 2000-2001 FY most of the developed countries' yield curve had turned to inverse shape. It indicates the upcoming bearish market.

The flat yield curve

A flat yield curve results when the yields are roughly the same for both short and long-term securities. This can happen for the same reason that the yield curve inverts. Either, the RBI may be raising short-term interest rates to contract the economy and fight inflation, or the long end of the curve may steep fall in anticipation of a recession and possible deflation both.

The yield curve flattened or inverted before all of the last seven recessions.

The Short period yield curve responds to mainly the monetary policy, the long-term end responds mainly to inflation expectation.

Indication of the yield curve

Probably, the yield curve would reveal before the economic expansion and contraction. The changes in the yield curve would tell us to forthcoming inflation and the monetary policy decisions.

Especially, long-term maturity securities so often change by forecasting inflation. During the expansionary phase, the interest rate spread might be higher than the normal spread.

the long-term curve if take up-turn that the economy is in an expansionary phase. At the same time, if the long-term take down-turn that the economy is going to worst.

Exchange rate

Every country trade with another country – both countries have to exchange money through common currency. Which is called drive currency. For example, India is largely using US Dollar as a drive currency except with few countries. This trading currency will be valued daily.

As of date 17.03.2021 USD/ INR -0.14

INR/ USD -72.58

In this way calculate the country’s currency with another country. The exchange rate contributes a major role in economic activities. Appreciation and depreciation both make an impact on the economy. the Few currencies are only recognized as stable currency by the international community.

The US Dollar, EURO, TEN, swiss franc, and Canadian Dollar, which are probably accepted by all countries. Usually, currencies would appreciate or devaluate against another currency.

What factors would make impact currency value?

Current Account deficit

Dollar index fluctuation

Commodity price volatility

Inflation

Interest rate

Currency Depreciation Advantage & disAdvantage

Depreciation of domestic currency will decrease the purchasing power

Depreciation of domestic currency will stimulate inflation.

Depreciation of the domestic currency will increase the import costs.

Depreciation of the domestic leads to widening current account deficit.

Export costs will be cheaper and more competitive to overseas buyers.

A higher level of exports would lead to an improving current account deficit.

An increase of exports can create aggregate demand following that GDP get fast growth mode

Currency appreciation Advantage & disadvantage

Appreciation of the currency should lead to cheaper import costs – domestic companies can not compete with imported product prices.

Exporting products would be more costs than foreign rivals so exporters will get struggle with price competition.

Shrinking exports would impact corporate sales and profits. This reason will create an unfavorably business environment.

Sudden changes in currency valuation affect the stock market. Especially export &import oriented business adversely affected by exchange rate fluctuation.

For example, information technology and pharma are highly dependent on the overseas market. Depreciation of the domestic currency will increase their income in Dollar terms.

Paints and petrochemical industries are highly dependent the imported crude oil. When an increase in crude oil prices affecting these industries operating margins and production costs.

Therefore, Exchange rate fluctuation will impact many industries so that, the stock market responds to exchange rate volatility.

The Important factor for exchange rate volatility

In terms of India, 80 percent of the crude oil demand fulfilled by imported oil due to a lack of natural resources. Crude oil is contributing 25 percent accounting for the total importing bill. The Crude oil price hike should lead to widening the current account deficit. The Current account deficit defines a balance between export and import bill.

Some key factors are impacting domestic currency. Such as the Current Account deficit, inflation, interest rate, and Dollar index.

The Current Account deficit defines a difference between the Export and import bill. If the export bill exceeds the import bill. this means the country is in a surplus trading account. contrary, a country is importing more than export which country is facing a trading deficit.

The current account surplus would strengthen the domestic currency, on the opposite side, a deficit of the current account will depreciate the domestic currency.

As I pointed out earlier, inflation would weaken purchasing power Which means inflation reduce currency value. Increasing inflation will depreciate currency value. In this scenario, the RBI should intervene to stop- fall of currency value.

RBI may increase the interest rate or purchase Dollars from the outside market.

Why does RBI hike the interest rate when being falling the currency value? Probably this kind of action is typically taken by the central bank. The main reason behind this, to attract foreign bond investors. More inflow of foreign currency will control the falling value.

When rising the interest rates, FIIS start to invest in the bond market, by an increase in the dollar inflow will protect the Indian currency depreciation.

The estimate of the inflation impact either the bond price and bond yield. Generally, the bond markets return highly depends on inflation. Therefore, inflation projection directly impacts the bond yield.

Current Account deficit

A country trading with various countries, if the country’s exports exceed than imports which country’s exports and imports account will be surplus. As well as, the country’s imports if it more than exports which country’s exports and imports accounts will be the deficit. The Surplus accounts may lead to strengthen the domestic currency, like that, the deficit accounts may lead to weakening the domestic currency.

So, the export-oriented business will get benefits while getting currency weakening.

Some companies are largely dependent the imported raw material and

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