What makes share prices go up and down is one of the most intriguing questions that investors face. If it were simple market forces of demand and supply, the answer would be simple—extra demand will pull prices up and the converse is also true. But what makes demand go up and down? Other than company specific reasons, there are a bunch of macro indicators that go into determining the demand for a stock. The big actors on the macro stage who we need to recognize are inflation, interest rates, government spending and finances and currency and just to make our lives even more complicated— they’re all interlinked. Here is how these actors affect you if you’re buying stocks directly and also if you have an equity exposure.
Inflation and interest rates
Markets like low and stable inflation since fast-paced price rise hurts both investor sentiments and the balance sheet of companies. Higher inflation raises input costs and many companies, due to highly competitive markets, are not able to pass these to consumers and are forced to take a hit on the margins. Lower margins, other things remaining equal, hurts profitability, and lower profits naturally lead to lower share prices. High inflation also dents the purchasing power of households which affects demand adversely. However, the biggest downside of higher inflation is that it is normally followed by higher interest rates. This cuts the ability of the firm to make higher profit as they now have to pay more in terms of interest on their borrowings. Higher interest rate also affects the ability of a firm to invest in building capacities as some of the projects become unviable at higher borrowing cost. Also, high interest rates move money from stocks to bonds further reducing demand. The uncertainty on demand front and higher cost of money lead to lower investment and lower growth. All this translates into uncertainty and lower stock prices. For instance, according to data compiled by the Reserve Bank of India, net margins for Indian companies narrowed to 4.8% in the third quarter of 2011-12 compared with 8.4% in same quarter last year. Provisional numbers for the third quarter 2011-12 also suggest that investment sanctioned by banks and financial institutions slowed to Rs 31,000 crore compared with Rs 80,100 crore in the same quarter last year.
Discipline in management of government finances is extremely important for investor confidence in the financial market. A government that runs high deficits has to borrow more and more from the market. Government borrowing, on the one hand, affects expansion and private investment, while on the other hand, higher government spending leads to higher demand, which becomes inflationary if production is not matched.
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Government borrowings crowd out the private sector borrowings by guzzling up all the money putting pressure on interest rates. For example, if there is Rs 100 in the financial system and government borrowing is at Rs 50, it will leave only Rs 50 for the private sector to borrow. If the borrowing needs of the private sector are above Rs 50, it will push up interest rates, resulting in some companies not being able to fund expansion, leading to lower future earnings and subdued share prices. Government of India, for example, in the current year is expected to run a fiscal deficit to the tune of 5.1% of the gross domestic product (GDP) and net borrowing is expected to be at Rs 4.79 trillion. The borrowing number can easily overshoot as it did in the last fiscal. In the fiscal 2011-12, the fiscal deficit shot up by 130 basis points of the GDP from budget estimates. One basis point is one-hundredth of a percentage point.
As a result, the market borrowings also shot up from the estimated Rs 3.43 trillion to Rs 4.36 trillion. If government was running a balanced budget, or a minor deficit, large part of this amount would have been available to companies for investments, which would have led to better earnings prospects and higher share prices. Higher deficit and the inability of the government to restrict expenditure also hurt investor’s sentiments and affects share prices.
External factors and currency
The Indian rupee has depreciated about 25% against the dollar in the past one year because of a combination of internal and external factors. The current account deficit, the difference between import and export of goods and services, reached an alarming level of 4.3% of the GDP in the third quarter of 2011-12 and as the inflow in the capital account, which is used to bridge the gap in the current account, has slowed due to an increase in risk averseness in the global financial system there is pressure on rupee. Large current account deficit combined with high fiscal deficit is a serious negative for the capital market. It not only creates complications in the macroeconomic management, but works as serious disincentive for investors due to possibility of economic instability in the country. Currency depreciation also puts strain on balance sheets in case companies have borrowed abroad. The unhedged interest liability of such companies in rupee terms would have gone up 25% because of slide in the rupee, which would have had serious implications on profits. Further, sliding rupee affects returns for foreign investors. Say a foreign investor bought share worth $100 when rupee was at 40 per dollar. If the currency slips to 50 per dollar, even if share price remains at the same level, the investment is now worth only $80.
Mint Money take
Any fundamental change in the direction of market will need triggers from the macroeconomic front. If inflation does not ease, it will prevent the central bank from cutting rates. Higher cost of money will neither allow investments to take-off, nor will it allow profitability to improve. Markets would also keep a tab on the intent and ability of the government to restrict expenditure in order to enable an investor-friendly environment. Progress on both these fronts will have an impact on capital flows and currency which is crucial for the stock market.