Influence of Macroeconomic Variables on Stock Return on the LSE

The study was carried out to examine the effect of three macroeconomic factors, on stock return in a global economy. The main objective of the study was to examine some peculiarities or differences in terms of the influence of selected macroeconomic variables on stock return in the London Stock Market. FTSE 100 Index of the London Stock Exchange has been used as a proxy for stock return, the dependant variable of the study. The study makes use of unit root, granger causality, correlation and multiple regression analysis to analyse the secondary data obtained from the London Stock Exchange.

There are numerous variables that have been identified to determine stock return in any economy. Three of these variables were investigated and the result of Granger causality uncovers some systematic causal relationship between stock return and inflation rate, and Stock return and money supply. The correlation and regression statistics evidenced positive and negative serial correlation.

The macroeconomic variables considered included broad money supply M4 (MS), Bank of England base rate (INTR) and consumer price index (INFR) with the aim of establishing their probable impact on stock return.

INTRODUCTION

1.1 OVERVIEW OF MACROECONOMIC VARIABLES AND STOCK RETURNS

In financial economics, a number of studies laid emphasis on macroeconomic factor being the causal effect of stock market movement. The stock market is a common feature of an economic growth and it is reputed to perform some necessary functions through which long-term funds of the major sector of the economy are mobilized and harnessed, which promote the growth and development of the economy. The stock market is an important factor in business investment decisions, because the price of shares affects the amount of funds that can be raised by selling stock to finance investment spending. Trends in globalization and introduction of varieties of new instruments being traded has made stock market complex. However, as economy develops, more funds are needed to boost the rapid growth of all facet of the economy. This makes stock market to serve as a tool in mobilizing and allocating of savings among competing uses which are critical to the growth and efficiency of the economy (Alile, 1997). As the stock market mobilizes savings concurrently it allocates a larger proportion of it to the firms with relatively high prospect as indicated by its rate of returns and level of risk.

Macroeconomic variables such as Money supply, Exchange rates, Interest rates, Inflation rate, Gross Domestic Product (GDP), Index of production, Unemployment etc have been identified as part of the major economic factors that affect stock returns (see for example, Chen et al., 1986, Fama, 1991, Arestis & Demetriades, 1997, Priestly, 1996, Taufiq Choudhry, 1999, Stijn Van Nieuwerburgh et al., 2005, Christopher Gan et al., 2006, Robert D. Gay, Jr., 2008, Athanasios and Antonios, 2009, e.t.c.). It is of importance to examine how these macroeconomic variables relate to stock market and their impact on expected return whilst minimizing risk. The effects of money supply cannot be over emphasized. As the economy grows stage by stage, monetary policy stimulates the economy and increases cash flow among individuals thereby making demands for financial assets point northbound. Stock prices increases as soon as the demands are translated to bid/ask market.

The Bank of England core purposes is to promote economic growth by maintaining price stability and supporting Government’s economic policies. The Bank of England performs its monetary stability function in other to ensure stable prices, low inflation and sustainable confidence in the currency. Monetary policy operates in the UK through influencing the price of money (adjustment of base rate – interest rate). In March 2009, the instrument of monetary policy shift towards the quantity of money provided as a result of the quantitative easing.

Source: Bank of England

Money appears to be a major influence on inflation, business cycles and interest rates. The relation between money and prices is historically associated with the quantity theory of money. There is strong empirical evidence of a direct relation between inflation and money supply growth. A country such as Zimbabwe which saw rapid increases in its money supply also saw rapid increases in prices. This is one of the reasons why monetary policy serves as a means of controlling inflation in the United States of America. Dhakal et al. (1993) suggested that money supply changes affect stock prices indirectly through their effects on real activity. Chong and Goh (2003) examine macroeconomic variables such as money supply and interest rate and re-affirmed the efficient market hypothesis (EMH). EMH suggest that competition among the profit-maximizing investors in an efficient market will ensure that all the relevant information currently known about changes in macroeconomic variables are fully reflected in current stock returns, so that investors will not be able to earn abnormal profit through prediction of the future stock market movements. Schwert (1981) results contradict the efficient market hypothesis. Schwert examines the stock market reaction to the monthly CPI inflation rate announcement and does use a measure of unexpected inflation rather than just the announcement rate.

Chart 2: Price Inflation – CPI, RPI and RPIX (Percentage changes over 12 months)

Source: Office for National Statistics

The CPI is the main UK measure of inflation for macroeconomic purposes and forms the basis for the Government’s inflation target. High rate of inflation is linked to the excessive growth of money supply. But low or moderate rates of inflation are more varied as there are no sustainable factors being determined. However, low or moderate inflation may be attributed to fluctuations in real demand and supply for goods and services as well as to growth in money supply which in turn lower the demand for stocks and assets. More views are on the opinion that a long sustained period of inflation is caused by money supply. Lee and Wong (2005) estimated the threshold levels of inflation for Taiwan and Japan using quarterly data set from the period between 1965- 2002 for Taiwan and 1970-2001 for Japan. Their estimation of the threshold models suggest that an inflation rate beyond 7.25% detrimental for the economic growth of Taiwan. On the other hand, they found two threshold levels for Japan, which are 2.52% and 9.66%. They argue that rate of inflation is positively related to money growth and the rising interest rates and inflation affect corporate earnings leading to lower stock returns. The findings of Lee (1992) supported the findings of Najand and Rahman (1991) and Shcwert (1989) in that there is strong evidence of the causal relationship that exist between inflation and stock returns.

The Bank of England sets interest rates to keep inflation low, issues banknotes and works to maintain a stable financial system. Interest rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. The extent of interest rate in determining the stock return movement has been studied. It is widely accepted that increase in interest rate would increase the required rate of return and share price would decrease with increase in the interest rate (see Gan et al., 2006). The relationship between stock returns and nominal interest rates reflects the ability of an investor to change the structure of her portfolio (Apergis and Eleftheriou, 2002). French et al. (1987) responded negative relationship existence between stock return and interest rate. Bulmash and Trivoli (1991) studied US stock market in relation to money supply and Treasury bill rate. They found negative relationship between stock returns and Treasury bill rate but positive relationship between stock returns and money supply. Islam and Watanapalachaikul (2003) examined Thailand economy between the period of 1992 to 2001. They argue that interest rate, bonds price, foreign exchange rate, price-earning ratio, market capitalization and consumer price index show a significant long-run relationship with stock returns.

Although the precise cause and effect relationship between economic variables and stock returns is unknown, they are believed to be related. The link between stock market performance and economic growth has been studied among analysts with a reference on both developed and emerging markets. Geske and Roll (1983)