Economic impact on stocks

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Wednesday, 04 May 2011 15:00 Anthony Galliano

The price of stocks is set by the marketplace, where investors meet to fix prices, determined by supply and demand.

The demand side is represented by buyers, the supply side is represented by the sellers. The price buyers are willing to pay depends on many factors. The fundamentals of a stock such as its earnings per share, price to earnings multiple, future earnings stream and dividend yield are seen as influential long-term determinants.

Investors also closely monitor economic factors which can sway markets short-term and also impact general long-term market direction.

The main economic indicators that affect stock prices are inflation, unemployment and gross domestic product. Additionally, interest rates, bond prices, currency exchange rates, and commodity prices are also affected by these economic indicators, which in turn greatly impact the direction of the market.

Inflation is the rise in general prices of goods and services in an economy. The rate of inflation is measured by annual changes in price indexes such as the Consumer Price Index and Producer Price Index.

The Consumer Price Index is a market basket of different types of consumer goods and services such as clothing, rent, food and energy.

The Producer Price Index measures price changes for goods and services at the wholesale level, from raw material to finished goods. Inflation erodes the purchasing power of money, as the value of goods and services increase it costs more dollars to purchase them.

Progressive inflation of 2-3 percent is generally viewed as acceptable, however if inflation is increasing rapidly, interest rates will increase to keep inflation in check.

Interest rates play a major role in determining stock market trends.

When interest rates are low or are falling, stock prices generally rise. Companies will have lower borrowing costs and thus it is cheaper to finance projects and operations. Lower borrowing costs should positively affect earnings and thus lead to higher stock prices.

Bond prices also increase when interest rates are declining.

Bondholders will hold on to their bonds in a falling interest rate environment because the rate of return they are receiving is higher than that being offered by newly issued bonds and the value of their bonds is also increasing.

With the increase of the supply of money in the economy due to lower interest rates and increased borrowing, commodity prices are also likely to increase. A rapid increase in commodity prices will affect the whole economy and lead to higher prices and inflation.

To temper inflation, interest rates will increase and lead to higher borrowing costs. This makes it more difficult and expensive for companies to raise capital leading, to a decline in stock prices as investors anticipate lower earnings.

Bond prices also decline as the current yields are adjusted upwards to keep pace with interest rates. Bondholders are concerned with the real rate of return which is the yield minus the rate of inflation. As inflation and interest rate increase, the market demands higher yields. Therefore, in an inflationary environment with rising interest rates, stock and bond prices typically both fall.

Movements in stock prices are not solely based on fundamentals, but are also greatly influenced by economic factors which can dictate overall market direction.