Saturday, February 22, 2014

Macroeconomics and Stock Movement

Macroeconomics and Stock Movement
 High deficits incurred by the government are detrimental for the economy in Long Run, because they lead to not only higher inflation, but also higher interest rates and also threat of downgrading of ratings on government securities. In Short run good for development.
 Interest Rate directly proportional to Repo Rate-
Repo Rate or Fed Fund Rate is the rate at which RBI or Fed sells securities. Interest Rate or Bank Rate is the rate at which Bank Lends money to commercial banks.
 Liquidity Adjustment Facility - The gap between the reverse repo rate and the repo rate is called the LAF corridor. The LAF corridor also influences the call money rate in the system. Call Money rate is the overnight inter-bank borrowing rate. The Call Money Market is the most active and sensitive part of the organized money market in the country because it registers very quickly the pressures of demand and supply for funds operating in the money market. The LAF corridor provides a theoretical floor and ceiling for the call money rates.
Generally-
 As Bank Rate increases, banks will borrow less money in turn decreases supply of money also leading (see Foreign Investment Flows) to currency appreciation and hence decreases in manufacturing, exports and consumer spending as such decreases Stock Price.
Also increase in Interest Rate leads to capital inflows and makes the home currency appreciate and this suggests that, nations product is expensive in other country (taking all other factors like inflation constant) in turn decreases export and has a negative effect on stock prices and for import dominant industries Interest Rate increase has positive effect on stock price.
 Interest Rates are directly proportional to Treasury yield. Interest rate increases so do the treasury yield in turn treasury bill ( bond, note) prices decreases. That’s why investment ratio between bonds and stocks should be done after properly analyzing economic conditions. As Interest Rate
increase has negative effect on stock price but will have positive on bond price.
Interest Rate in Long Run and Short Run-
 In the short term: The immediate impact of rise in interest rate is on companies with high debt in their balance sheet .The interest payment made by them rises which reduces their EPS. Thus there would be negative sentiments for such stock; resulting into depleted stock price.
 In the long term- high interest rate would have more sector specific impact. The sectors which are most impacted by high interest rate is the real estate, automobile and all the capital intensive industries. So, any investment by you in these sectors must be taken with a lot of caution during the situation of high interest rates.
Main Factors that Affecting Interest Rates
1. Monetary policy controls Interest Rate movements-
RBI loosens the monetary policy mainly in recession (i.e., expands money supply or liquidity in the economy), interest rates or bank rate tend to get reduced and economic growth gets spurred; at the same time, in long run it leads to higher inflation. On the other hand, if the RBI tightens the monetary policy mainly in inflation, interest rates rise leading to lower economic growth; but at the same time, inflation gets curbed.
2. Growth in the economy –
If the economic growth of an economy picks up momentum, then the demand for money tends to go up, putting upward pressure on interest rates.
3. Inflation: Inflation generally puts upward pressure on interest rates.
In case of points 2 and 3 sometimes Interest rates are high and currency is also depreciating in that case Federal Reserve uses either to spur growth by decreasing repo rate (as inflation already increased the home country products with depreciating currency) and increasing supply of money hoping for increase in manufacturing in turn export and aggregate demand to cover trade deficit and in some cases increases interest rates to pull back money from market to overcome inflation depending on the situation.
Factors Leading to Inflation-
Increase in demand and decrease in supply.
Demand side factors
a) Increase in nominal money supply: Increase in nominal money supply without corresponding increase in output increases the aggregate demand. The higher the money supply the higher will be the inflation.
b) Increase in disposable income: When the disposable income of the people increases, their demand for goods and services also increases.
c) Deficit Financing Policy: High government spending, Deficit financing raises aggregate demand in relation to the aggregate supply.
d) Black money spending: People having black money spend money lavishly, which increases the demand un-necessarily, while supply remains unchanged and prices go up.
e) Repayment of Public Debts: When government repays the internal debts it increases the money supply which pushes the aggregate demand.
f) Expansion of the Private Sector: Private sector comes with huge capitals and creates employment opportunities, resulting in increased income which furthers the increase in demand for goods and services.
g) Increasing Public Expenditures: Non developmental expenditures of government lead to raise aggregate demand which results as
increased demand for factors of production and then increased prices.
h) Speculation-Speculation is also increase demand especially gold and shares
Supply-side factors
a) Shortage of factors of production or inputs: Shortage of factors of production, i.e. raw material, labour capital etc causes the reduced production, which causes the increase in prices.
b) Industrial Disputes: When industrial disputes come to happen, i.e. trade unions resort strikes or employers decide lock outs etc the industrial production reduces.
c) Natural Calamities: Natural disasters, invasions, diseases etc effect the agricultural production, and shortage of supply.
d) Global factors: This factor includes the changing global environment. Most common example is the rise in oil prices. This factor of inflation may vary in nature, i.e. it can be political, strategic, economic in nature.
Exports & Imports-
 In short run if exports increases and import decreases it increases aggregate demand also importing countries currency supply increases in foreign markets in turn decreasing supply of currency of exporting country and exporting countries decreases in turn currency appreciates.
In Long run this appreciation makes exporting countries products expensive decreasing demand of product in turn exports and currency depreciates.
4. Global liquidity:
If global liquidity is high, then there is a strong chance that the domestic liquidity of any country will also be high, which would put a downward pressure on interest rates.
Interest rate affects Industry wise-
1. Capital intensive industries would be most affected by high interest rates but when the interest rates are lower they would be gaining the most. It is better to avoid investments in sectors such as real estate, automobiles etc when the interest rates are rising. 2. Companies with a high amount of loans in their balance sheets would be affected very seriously. Interest cost on existing debt would go up affecting their EPS and ultimately the stock prices. But during low interest rate these companies would stand to gain. 3. Sectors like Pharma and IT are less affected by interest rates.
The IT sector is more influenced by factors such as currency rate fluctuations, rising attrition level, visa restrictions, competition from the large global players and margin pressures. Certainly, IT sectors are not interest rate-sensitive. Pharma is considered as the defensive sector and investors can invest here during uncertain and volatile market conditions.
4. In a high interest rate scenario, companies with zero or near zero debts in their balance sheets would be kings. FMCG or fast moving consumer goods is one sector that’s considered as a defensive sector due to its low debt nature. 5. Banking sector is likely to benefit most due to high interest rates. The Net Interest Margins (It is the difference between the interest they earn on the money they lend and the interest they pay to the depositors) for banks is likely to increase leading to growth in profits & the stock prices.
Main Factors that Influence Exchange Rates
Exchange Rates & Supply and Demand
Purchasing Power Parity-
This theory essentially tells that exchange rate should be dependent upon the price level of both the countries. If the price of a basket of goods in India is P, the price of the same basket of goods in USA is P*, then the exchange rate e (expressed in terms of INR per dollar), should be determined by the following equation:
e.P*= P
or e = P/P*
1. Exporting and Importing Companies
The first group that has influence in the foreign exchange markets is typified by large, multinational corporations. Imagine a New York City firm exports its products to a German company. The business transaction will be settled in dollars so the American firm obtains revenue in its own currency and can pay its employees’ salaries in dollars.
To facilitate the transaction, the German firm needs to convert some of its capital from Euros to dollars on the foreign exchange market. The supply of Euros increases leading to an appreciation of the dollar and depreciation of the euro. It can also be said that the German firm increases the demand for dollars, again causing the dollar to appreciate in comparison to the euro. This transaction would have to be for a very large contract in order for the exchange rate to actually move a pip up or down.
Importing companies affect the demand of a currency as well. For example, an American retailer features Japanese furnishings and pays its suppliers in Japanese yen. If consumers like these products then they will indirectly contribute to an increase in demand for the yen as the American retailer will have to buy more merchandise from Japan. As the retailer purchases the yen and sells the dollar on the exchange market, the yen appreciates.
2. Foreign Investment Flows
Suppose an American company wants to open a factory in India. In order to cover the costs of the land, labor and capital the firm will need Rupees. Suppose the company holds most of its reserves in American dollars. It must sell some of its American dollars to buy Rupees.
Say initial equilibrium is at point A. The demand of Rs increases new equilibrium shifts to B, but supply of American dollars on the foreign exchange market will increase and the supply of Rupees will decrease equilibrium shifts to C, which causes the Indian rupee to appreciate against the US dollar. On the flip side, Foreign investors are also increasing or decreasing the demand for the currency of the country in which they are interested in investing.
$/Rs C
B
A
Quantity of Rs
If in the situation of excessive capital inflows, RBI intervenes by purchasing excess dollars, it can maintain the competitiveness of Indian exports, but may lose control over money supply. On the other hand, if in such a situation, RBI does not intervene, it would have greater control over money supply, but the competitiveness of Indian exports would go down. There are a couple of alternatives to deal with these conflicts. First, the central bank can moderate some of the pressure on the rupee to appreciate by encouraging private investment overseas by Indian businessmen or by allowing foreigners to borrow from the local market. This way the excess supply of dollars can be reduced
without any need for RBI intervention. The second alternative is to sterilize the capital inflows, which is elaborated below.
Sterilization - When the central bank buys foreign exchange from the market in exchange for rupees to keep the nominal exchange rate of the domestic currency from appreciating, it creates excess supply of rupees (relative to demand) in the
Market. Subsequently, the central bank mops up the excess supply of rupees by selling government securities in open market operations. When the central bank sells government bonds in the market, it implies that economic agents are buying these papers by paying money to RBI from the existing supply of money. This reduces money supply in the economy. This whole exercise of mopping up excess supply of rupees from the market is called sterilization of capital flows.
FDI details of India (www.dipp.nic.in)
3. Inflation
If inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy fewer imports. Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency in long run.
4. Interest Rates
If in home country interest rates rise relative to elsewhere, it will become more attractive to deposit money. You will get a better rate of return from saving in the countries banks; therefore demand for currency will rise. Higher interest rates cause an appreciation. This is known as “hot money flows” and is an important short run factor in determining the value of a currency.
5. Speculation
If speculators believe the sterling will rise in the future, they will demand more now to be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of the financial markets. For example, if markets see news which makes an interest rate increase more likely, the value of the pound will probably rise in anticipation.
6. Change in Competitiveness
If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation.
7. . Relative strength of other currencies.
In 2010 and 2011, the value of the Japanese Yen and Swiss Franc rose because markets were worried about all the other major economies - US and EU. Therefore, despite low interest rates and low growth in Japan, the Yen kept appreciating.
8. Balance of Payments
A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial / capital account then this is OK. But a country, who struggles to attract enough capital inflows to finance a current account deficit, will see depreciation in the currency
9. Government Debt.
Under some circumstances, the value of government debt can influence the exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds causing a fall in the value of the exchange rate.
For example, if markets feared the US would default on its debt, foreign investors would sell their holdings of US bonds. This would cause a fall in the value of the dollar.
10. Government Intervention
Some governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.

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