Chapter 10: Economics for Stock Market

Chapter 10: Economics for Stock Market

10.1 Introduction

Economics can be divided into two broad categories:

• Microeconomics
• Macroeconomics

 Microeconomics focuses on the study of individual decisions taken by businesses, households, workers, etc. Macroeconomics focuses on the study of decisions taken by countries and governments and assesses the economy as a whole. Macroeconomics deals with issues like inflation, growth, inter-country trades, unemployment etc. Microeconomics and macroeconomics are complementary to each other. Microeconomics is similar to a bottom-up approach where businesses need to be analyzed first followed by industry and country. Macroeconomics is more like a top-down approach, where the country is analyzed first and subsequently industry and businesses.   

Common macroeconomic factors and their impact on stock markets

The most common macroeconomics factors are Gross Domestic Product (GDP), unemployment rate, inflation, interest rate, government debt, business cycles, etc. We can summarize the impact of these factors in the following table:

10.2 Inflation

In India, the government has created a basket of essential goods and services and assigned weightage to each commodity and service. A general increase in prices of commodities and services in this basket is known as inflation. Inflation numbers are declared by the government between the 11th to the 14th of every month. In India, inflation is measured by two methods:

Consumer Price Index (CPI) and Wholesale Price Index (WPI). CPI measures price change at the consumer level, while WPI measures price change at the wholesale level.

 The purchasing power of money denotes what amount of goods your money can buy in the future, and it is directly linked to inflation. Due to inflation, you will not be able to purchase the same goods after a certain period. Let us understand this with an example:

Assume you have Rs.100 with you today. With this money, you will be able to purchase 2 kgs. of sugar from this. After a year, due to rise in prices of sugar, the same 2 kgs. of sugar will cost Rs. 110. Now, with your Rs.100, you will not be able to purchase the same goods, reducing your purchasing power.

Your investments must earn returns that are higher than inflation to maintain your purchasing power.  

How is inflation measured?

Consumer Price Index (CPI) and Wholesale Price Index (WPI) are widely used to measure inflation in India. CPI measures the price change at the consumer (retail) level, while WPI measures price change at the wholesale level. Usually, the value of CPI is higher than WPI. To measure inflation, the government has created a basket of essential goods and services and assigned a weightage to each commodity and service. In India, the basket of goods for CPI is composed of the following groups:

  Change in prices of these goods and services decides the value of CPI.   

Headline and core inflation

 Headline inflation measures overall inflation figures reported as CPI. Core inflation removes volatile items like food and fuel from CPI, making it more stable.

Inflation numbers are published by the Indian Ministry of Statistics and Programme Implementation every month with a lag of one month. Usually, these numbers are published between 11- 14th of every month.

Inflation range

On a periodic basis, RBI reviews the monetary policy and takes corrective action to control inflation as per the present scenario. Usually, CPI ~ 4% could be considered as good inflation.

 Very high or low inflation could adversely impact the economy.   Very high inflation leads to high prices of goods and they become unaffordable for the general populace.  Purchasing power of money will also reduce drastically in this scenario causing the economy to collapse. In the past, there have been instances of very high inflation in a few countries like Zimbabwe and Venezuela.  Inflation rates were as high as 400,000 % p.a. in those countries.

Similarly, low inflation indicates decreased demand for goods and to maintain equilibrium, supply is also on the lower side. If supply does not increase, growth in industry output will reduce and the economy will slow down. If inflation becomes negative, it may lead to closure of industries and increase unemployment. Hence, it is very important to maintain inflation at a steady, desirable range so that goods remain affordable to consumers and growth opportunities for industries will also be aplenty. It is like riding a bicycle, where you need to continuously keep pedaling to move and maintain balance.

RBI controls inflation through changes in monetary policy. The definition of inflation is "more money chasing too few goods".  This means that the main reason for inflation is higher money supply in the market. To control inflation, the RBI needs to regulate money supply through available tools in the monetary policy. These tools include repo rate, reverse repo rate, CRR, SLR and OMO.

Deflation

When inflation becomes negative, it is termed as deflation.  In this situation, supply exceeds demand, and to maintain equilibrium between demand and supply, supply needs to be reduced. At the same time, a stimulus package should be provided to increase demand.

Deflation is not good for the economy, as it leads to a slowdown and increase in unemployment. It will lead to closure of industrial units, layoffs and take the entire economy into a recessionary phase. That is why it is important to maintain a healthy inflation rate in the economy for sustainable growth.

10.3 Monetary and fiscal policy

The central bank of the country, RBI and the government play a key role in the economic situation of the country. RBI controls money supply by altering interest rates through the monetary policy to control inflation. Government influences demand in the economy by managing tax rates and government spending through fiscal policy. These policies can be used to accelerate growth when an economy starts to slow or to moderate growth when an economy starts to overheat. Besides, fiscal policy can also be used to redistribute income and wealth among people.

The government can also amend tax rates for different sets of people to redistribute wealth and manage incomes. Similarly, the government can increase or reduce expenditure to increase and reduce demand respectively. The common goal of both monetary and fiscal policy is to create a conducive environment for stable growth and controlled inflation.

Money supply (Liquidity)

Liquidity means easy availability of money in the market.  Supply of money encompasses the total stock of money (paper notes, coins and demand deposits of banks) in circulation held by people at any particular point of time. Low interest rates are a sign of good liquidity in the market.

Central bank of the country (RBI) can control the money supply through various monetary policy tools like CRR, Repo Rate, SLR, OMO, etc.

10.4 Monetary policy tools

There are various tools available in the hands of RBI for managing circulation of money in the economy. The primary job of the RBI is to control inflation while helping maintain sustainable growth.

We are discussing a few important tools here:

10.4.1 Repo and reverse repo rates

Repo rate is the rate at which commercial banks can borrow money from the RBI to fulfill their requirements. Reverse repo rate is the rate at which commercial banks can part with their excess money and park it with the RBI. Usually, the repo rate is 50 basis points or bps (100 bps = 1%) higher than the reverse repo rate. Repo rate works as the base rate for most loans. If repo rate increases, interest rates in the market will also increase and borrowing will become costlier. High interest rates adversely impact industries as interest outgo will increase and their profits are likely to shrink. Similarly, the cost of your loans will also increase with an increase in repo rates. Most loans like home loans, personal loans, vehicle loans etc. are provided on a floating rate basis and their interest rates are market linked. An increase in repo rate will increase these rates and lead to higher EMI payments and reduced savings. When money supply is in excess, the RBI may increase the repo rate and vice versa.

Impact of change in repo rate on equity and debt markets

 High repo rate is negative for the equity market as it increases the cost of capital for capital- intensive industries. Many sectors like infrastructure, capital goods and cement require huge capex, and these sectors are likely to be affected the most.  High interest rates are also negative for the banking sector as it slows down credit demand in the market. As far as the debt market is concerned, prices of securities are inversely proportional to interest rate. An increase in the rate, increases yield but reduces the prices of securities leading to a loss for existing investors.

Interest rate is inversely linked with growth. High interest rate hampers the growth of the economy because of the increase in the cost of capital for businesses.

10.4.2 CRR

Cash Reserve Ratio (CRR) is the percentage of deposits that banks need to maintain in cash form with the RBI. If the CRR rate is 4% and the bank has a deposit of Rs. 100, then the bank needs to keep Rs. 4 with the RBI in cash form. In India, the banking system works on the fractional reserve principle and CRR helps in money creation.

Let us understand this with an example:

 Assume that CRR is 4%. Mr. A has received Rs. 100 by selling a government bond. He has deposited Rs. 100 with Bank 1. At this stage, the total money in circulation is Rs. 100. Bank 1 will deposit Rs.4 with the RBI as CRR and lend the remaining Rs. 96 to Mr. B. Now, the total money at this stage becomes Rs. 100+96 = Rs. 196 (Mr. A holds Rs. 100, Mr. B hold Rs. 96). Mr. B deposits his Rs. 96 with Bank 2 and Bank 2 now deposits 4% of Rs. 96 i.e. Rs. 3.84 with the RBI as CRR and lend the remaining Rs. 92.16 to Mr D. At this stage, total money in the system is Rs. 288.16 (Rs. 100 of Mr. A in Bank 1, Rs. 96 of Mr. B in Bank 2 and Rs. 92.16 in the hands of Mr. C). This chain will continue and the total money in the system can go up to Rs. 100/.04 = Rs. 2500 i.e. 25 times the actual money.

 If the RBI decides to increase the CRR to 5%, the total money could reduce to Rs. 100/.05 = Rs. 2000 i.e. 20% less than the previous value. So, even a small change of 25 bps (100 bps =1%) in CRR can significantly impact money supply. However, in reality, lending and circulation of money is not to the extent of 100% but still, it is an important tool to control money supply due to the multiplier effect.    

10.4.3 SLR

Statutory Liquidity Ratio (SLR) is the percentage of deposits (net demand and time liabilities) that banks need to keep in liquid asset classes like cash, gold, RBI-approved securities etc. This deposit is over and above the CRR deposit. For example, if the CRR ratio is 4% and the SLR ratio is 20%, it means that 24% of the amount available with banks is blocked and the remaining can be used for lending purposes. If the RBI increases SLR, less money will be available to banks to lend and it will reduce money supply. Similarly, money supply can be increased by reducing SLR.  

10.5 Gross Domestic Product (GDP)

GDP means Gross Domestic Product. GDP is the value of goods and services produced in the country in a financial year. GDP is an important tool to estimate the size and growth of an economy. When we say that the economy is growing at a rate of 5%, it means that GDP real growth rate is 5%.

 Real GDP growth rate can be measured by a change in the value of goods and services produced, keeping the rate constant equivalent to the base year. Let us understand this with a hypothetical example:

Assume that our economy only produces two goods, computer and wheat.

In the above example, the GDP growth rate is 7.5%.

10.6 Budget and fiscal deficit

The union budget is the annual financial statement of the government presented on February 1 each year. It is a statement of estimated receipts and expenditure of a government for an upcoming financial year. The major highlights of the budget are personal income tax rates, financial deficit target, policies related to various industries, subsidies, etc. A budget is known as fiscal deficit budget if government expenditure is more than income earned during a financial year. Similarly, it is known as surplus budget if revenue is more than expenditure.

Fiscal deficit is the difference between the total revenue and expenditure of a government in a financial year. The major cause of deficit is an increase in capital expenditure or fall in revenue. This also defines the borrowing needs of a government. The government’s major source for earning revenues are different types of taxes like income tax, GST, excise duty etc. while non-tax revenue includes dividends, interest income, etc. The government has estimated the fiscal deficit for the financial year FY 19-20 at Rs 7.03 lakh crore, aiming to restrict the deficit at 3.3% of (GDP). In India, the FRBM (Fiscal Responsibility and Budget Management Act) Act suggests bringing the fiscal deficit down to about 3% of the GDP as the ideal target.

A high fiscal deficit is not bad all the time.  Sometimes, it can also boost economic growth and lead to creation of new jobs.

Current Account Deficit (CAD)

Balance of Payment (BOP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period, usually one year. Balance of Payments (BoP) consists of two accounts: current account and capital account. Primarily, current account records all import and export of goods and services and unilateral transfers, while capital account records purchase and sale of foreign assets and liabilities. When a country's import is more than the export, then it is known as Current Account Deficit (CAD).

It is important to keep the CAD under control, otherwise it can impact the nation's currency. A higher CAD could impact the currency badly and lead to sharp fall in currency value. India's CAD deficit had narrowed down to 2% of GDP in the first quarter of FY 19-20. At one point, CAD touched a high of 4.8% of GDP in 2012-13 on rising gold and oil imports, which also impacted the rupee at that time, causing it to depreciate rapidly.

How does government manage its fiscal deficit?

The government makes up for the fiscal deficit by borrowing an equivalent amount from the market. The government's objective is to control fiscal deficit without compromising on economic growth. To control fiscal deficit, the government can reduce capital expenditure, cut down expenses or increase revenue.

Impact of government policies on fiscal deficit

Government policies have a major impact on the economic condition of a nation. Fiscal deficit is the difference between government expenditure and revenue in a financial year. Government policies related to taxation can impact revenue which subsequently affects fiscal deficit. Fiscal deficit is affects both revenue and expenditure, so if the government earns less revenue but is also, simultaneously, able to cut down expenses, fiscal health will remain more or less unimpacted.

Impact of subsidy on fiscal deficit

Fiscal deficit is the difference between government expenditure and revenue in a financial year. Government decisions related to subsidies can impact expenditure and accordingly affect fiscal deficit. If the government decides to increase subsidy amounts, it can widen the deficit gap. Fiscal deficit affects both revenue and expenditure, so if the government increases its revenue, then it can afford to pay higher subsidies without widening the deficit gap. 

10.7 Impact of FII and FDI flow on markets

FIIs are foreign institutional investors who are based in a country other than the one in which they are investing. These FIIs are typically big investors including pension funds, mutual funds, insurance companies, hedge funds etc. Since they are able to invest large amounts, FIIs are able to influence market trends. These investments also work as catalysts for price movement if FIIs take a position. Conversely, it can also trigger a sell-off if FIIs exit from particular stocks.

Foreign Direct Investment (FDI) is investment made by foreign companies in India to set up/start a business. They open up an establishment in the country on their own or collaborate with a local partner to carry out business. These investments are as per policies of the government related to that sector. India is a huge and attractive market and attracts significant amount of interest and FDI.

10.8 Sovereign rating

Sovereign rating is the rating of a country given by international credit rating agencies like S&P, Moody's, Fitch etc. based on per capita income, GDP growth, inflation, external debt, economic development and default history. In a nutshell, it is the creditworthiness of a nation and its government's ability and willingness to service its debt in full and on time. Sovereign ratings influence the cost of capital at which countries can obtain credit in international financial markets. A country's rating history is useful for international organizations like the World Bank and IMF which provide credit and aid to countries. Many international investors and funds also monitor sovereign ratings while making investments and taking credit decisions. Some institutional investors are only allowed to invest in debt above a certain rating level. Thus, sovereign ratings affect a country's access to global capital markets and capital flow.

India’s sovereign rating is BBB, which is the last investment-grade rating. Sovereign rating does not depend only on economic growth or default history.  There are few other factors like per capita income, inflation, external debt also making an impact on the final rating. Except for high economic growth and no default history, if the other factors are not in very good shape, it results in poor sovereign rating.

10.9 Business cycles and economic indicators

Business cycles depend on production output of goods and services in the economy. We can classify these cycles into six stages:

Expansion: In this stage, there is an increase in employment opportunities, incomes, production and sales. In this phase, the economy has a steady flow in money supply and investments earn good returns.

Peak: This is the highest level of the economy, beyond which it becomes stagnant resulting in no growth. Inventories also start piling up due to stagnant demand.

Recession: In this stage, the economy starts shrinking.   Unemployment level starts rising, production and prices start falling. Income levels also eventually fall.

Depression: Unemployment and production levels continuously keep falling and business confidence is at its lowest.  Getting credit for business becomes difficult.

Trough: This is the lowest level in the economy and recovery will start at this point.

Recovery: This stage shows recovery signs, where demand starts rising. There is an increase in prices, production and employment levels.

It is difficult to identify business cycle stages as the duration of these cycles cannot be assessed accurately. Typically, one cycle lasts for around four-five years, but many-a-times, it could be longer or shorter than the average length. The stage of a cycle that we are currently could be predictable sometimes, but when there is a change from one to another, it is difficult to predict due to overlapping. At this point, economic data could be confusing and may not give a clear picture. Otherwise, business cycle stages can be identified by analyzing economic indicators like inflation, production demand, per capita income, unemployment data, etc.   

Business cycles and market

The stock market is a leading economic indicator, which means that the stock market changes before the actual change in the economy takes place. In a normal scenario, the stock market always moves up when the economy is in the up-cycle. In some cases, when the economy reaches close to its peak, a fall in the stock market could indicate recession. Otherwise, temporary ups and down are natural characteristics of the stock market.

 Cyclical industries, where demand and profitability are directly linked to the economy, are most affected by changes in business cycles. These sectors include capital goods, infrastructure, cement, metals industries etc.  Sectors like pharma and FMCG are least affected by changes in business cycles.

Economic indicators

Many economic indicators can help us understand the condition of the economy. Some common indicators are the stock market, advance tax deposits, Index of Industrial Production (IIP), GDP, inflation, interest rates, Current Account Deficit (CAD), Purchasing Manager Index (PMI), crude oil prices, etc.

Index of Industrial Production (IIP)

IIP is an index that tracks manufacturing activities of various sectors in an economy. IIP data broadly covers the activity in the manufacturing, mining and quarrying and electricity sectors. IIP data is published by the government every month with a lag of around six weeks. Though IIP indicates the condition of the country’s economy, it should not be taken as the sole basis for investment. IIP data is broadly divided into three segments – manufacturing (79.36%), mining and quarrying (10.47%) and electricity (10.17%).

Purchase Manager Index (PMI)

PMI is an indicator of business activities in the manufacturing and services sectors. PMI captures information through surveys of purchasing managers of various companies about their perception related to production levels, order from new customers, inventories, etc. It is one of the best leading economic indicators to forecast future economic scenarios.  

Crude oil

Crude oil prices are also important economic indicators for the Indian economy. Crude is one of the major constituents of our import bill and change in crude prices has a major impact on our trade deficits. Higher crude oil prices may widen CAD and it may be considered as a negative factor for the Indian economy. Falling crude prices reduce import bills and help us in reducing CAD. So, falling crude prices are considered positive for the Indian economy.

If GDP growth rate is high, it is a sign of a good economy. Higher IIP numbers are also a sign of growth in industrial output. Inflation should be in the normal range; very high or low inflation are not good signs. Low interest rates are desirable in an economy for growth. If the economy has high interest rates, it is not a good sign. CAD within the range of 3-4% of GDP is considered normal, and debt beyond these limits can adversely impact the economic scenario.  However, it may be possible that one of the indicators shows a different picture of the economy. It is always better to collectively analyze indicators to understand the state of the economy.

Economic indicators and stock markets

The stock market takes cues from the health of the economy.  Economic indicators help investors understand the state of the economy so that they can manage their investments as per the current scenario. Some of the leading indicators also help investors forecast the next stage of business cycles.

The stock market is also an important indicator of the economy. Any broad stock market index which covers a majority of sectors and companies could be a good predictor of the economic condition of a country. The GDP of a country depends on the production output of companies and the stock index is a good representation of these companies. That is why a broad stock index is a good indicator of the health of an economy.

GDP, PMI, IIP data, etc. are highly positively correlated with the stock market. Conversely, interest rate, unemployment data, inflation, etc. are highly negatively correlated with the stock market.

Growth in IIP numbers is a good sign for cement and steel industries. IIP data is purely industrial data. The banking sector is not included in it. But increase in production and investment activity is usually financed through borrowings from banks. If industrial production and capital spending increase, then it is likely to have a positive impact on the banking sector.

Capital intensive industries are most affected by high interest rates but when interest rates are lower, they gain the most. It is better to avoid investments in sectors such as real estate, automobiles etc. when interest rates are rising.

Companies with a high proportion of loans in their balance sheets are affected very seriously by high interest rates. In a high interest rate scenario, companies with zero or near zero debts in their balance sheets will benefit most. FMCG is considered as a defensive sector due to its low debt nature. Rising interest rates are associated with slower growth rates of bank loans and deposits.

Sectors like IT are less affected by interest rates. The IT sector is more influenced by factors such as currency rate fluctuations, rising attrition levels, visa restrictions, competition from large global players and margin pressures. Certainly, IT sectors are not interest rate sensitive.

10.10 Important dates for stock markets

Disclaimer:

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