Mind the macros: How rupee moves, inflation affect stocks

Stock market movements are affected by numerous factors and events. In order to understand and study these aspects and their impact, we have classified them into two broad categories: macro and micro.

Macro factors play out on the entire economy or a particular sector, but do not include those affecting individual entities, which are covered under micro factors. Stock markets respond to developments in these factors over time, or move in anticipation of events or developments in the economy, a sector or individual stocks.

Here, we take a look at the impact of macro factors on an equity portfolio.

There are numerous macro variables affecting an economy. These are:

· Money supply in any economy has a considerable effect on the other macroeconomic variables, depending on the strength of the money multiplier.

· Consumer price index is a reflection of inflation in the economy. If high, it could threaten macroeconomic stability, making the stock market more volatile.

· In trading economies, the exchange rate has a great influence on stock market behaviour. India is dependent on other nations for more than three-fourth of its crude oil requirements. Any movement in international crude prices considerably affects the domestic economy, and is ultimately reflected in our stock markets.

· The repo rate, opted for by RBI as a monetary management instrument, is either a stimulus or disincentive to the market in terms of investment decisions. This is obviously reflected in the movement of the stock market. Interest rates show a negative and statistically significant relation with stock returns. A reduction in interest rate lessens the cost of borrowing, serving as an incentive for firms and increasing their stock prices.

· Industrial growth rates lead to increased confidence in the economy, hence more faith in the stock market.

A favourable macro environment is a boon for the stock market. In such a scenario, stocks can trade with high PE values, and the faith in the stock market improves considerably.

Numerous studies have been conducted to establish a correlation between individual macro-economic indicators and the equity market.

However, since there is a cross-correlation between these factors (many of them show a similar influence on the equity markets), it is very difficult to quantify the magnitude of the impact of an individual factor.

Inflation shows a positive relation with stock returns, as equities serve as a hedge against inflation.

Exchange rate also has a positive, but insignificant relation with stock returns. In the case of money supply, the positive relation indicates that an increase in money supply leads to economic stimulus, resulting in increased corporate earnings, hence leading to an increase in stock prices.

Exchange rate and stock returns have a positive relationship with each other. Depreciation of currency leads to an increase in demand for exports, thereby increasing cash flows into the country, with the assumption that demand for exports is elastic.

An investor can, therefore, try to identify the few key macro factors that affect his/her portfolio, and keep track of the same in order to help make appropriate decisions.

For example, generally inflation has a negative effect on FMCG stocks, as it reduces discretionary spending of consumers. However, this relationship might not hold true every time. Falling inflation can end up hurting FMCG companies as well.

In what scenarios do companies not benefit to a great extent when costs decline? This happens when this period coincides with weakening consumption demand, urban demand affected by poor economic growth and rural demand being adversely affected by bad weather and falling rural wage growth.

When costs decline in such an environment, larger companies fear they will lose market share to smaller ones if they keep prices unchanged. Tough economic conditions unhinge brand loyalty quite easily, as consumers try to make every rupee count.

Another example would be the effect of interest rate changes on the banking and finance sector. Rising interest rates signal a strengthening economy, which usually means that borrowers have less difficulty making loan payments, and banks have fewer non-performing assets. It also means that banks can get higher net interest margins — the spread between what they pay deposit holders and interest earned from highly-rated debt like treasuries.

However, this depends on what percentage of the bank’s lending is on a floating rate basis, and how much on a fixed rate basis.

An investor will, thus, have to shortlist a few macro variables that could have an impact on his portfolio constituents, and largely ignore the others so that they don’t cloud his thinking.

This will have to be combined with tracking micro developments to check whether the macro developments get offset or reinforced by the former, so that the investor can take necessary action. This, at times, could also include ‘no action’.

An indicative list of macro variables that can be tracked by investors in five select sectors is given in the table below: