BusinessEconomics

Factors impacting financial and stock markets

Author: Xiaofei (Sophie) Sun
The Ethel Walker School
February 27, 2021


Part 1: Introduction

This paper discusses factors that impact financial and stock markets. Some factors have a direct influence on the stock market. When GDP increases, the stock market also rises. If the CPI shows inflation, then the stock market falls. Political events or news also impact the stock market directly because if there is bad news, the stock market will fall. The higher the productivity is, the higher the stock market will rise. During the pandemic, there was a financial crisis, which caused a fall in the stock market. When the ‘animal spirit’ is high, people get more optimistic about the stock market. Unemployment is negatively correlated to the stock market because the higher the unemployment rate, the more stock prices fall. When the monetary policy is strict, the stock market will decrease. Different factors have different levels of impact on the stock markets.

Part 2: Literature Review

One of the factors that impacts the financial and stock markets is the Gross Domestic Product, which measures a country’s total income and expenditure. It is composed of consumption, investment, government purchases, and net exports. GDP is the main indicator of a country’s economic well-being. Future GDP affects the stock markets. If the growth rate of GDP increases, the financial and stock markets also rise. If the growth rate of GDP decreases, the financial and stock markets fall. For example, during the pandemic in 2020, the GDP decreased a lot because since people mostly stayed at home, stores, restaurants, and factories closed, which led to low consumption, investment, government purchases, and net exports. The stock markets also decrease because of the pandemic and low GDP. However, when the GDP was high, the economy of the country was better. Therefore, the financial and stock markets also increase. The GDP has a significant impact on the financial and stock markets.

The Consumer Price Index (CPI) also impacts the stock market. It is the measure of the overall level of prices and the overall cost of goods and services. CPI tracks the cost of the typical consumer’s “basket” of goods and services. It corrects economic variables for the effect of inflation. CPI shows the direction of prices, and it is an indicator of inflation. According to research, “if the consumer cuts back spending because basic expenses are too high, a recession usually follows, and this means lower earnings for public companies and lower prices for their stocks” (Duff). When the CPI increases and shows inflation, the Federal Reserve will raise interest rates and remove money from the system. This action makes operating a company harder and causes companies to pull back and slow consumer spending. Then, the economy moves into recession, and the stock prices fall. So, if the company’s business slows, the stock prices would fall.

Current events and political events also influence the stock market. For example, the stock market has been a rollercoaster since COVID 19 started. The market falls during the lockdowns and rises when vaccines are in progress. Changes in political events affect the stock market because it affects companies’ profitability and changes the stock price. Stock prices react to negative news more than positive news. If the event is negative, it will cause the stock market to change a lot compared to a positive event.

Productivity is a leading indicator for the stock market. A country’s standard of living depends on its ability to produce goods and services. The higher productivity is, the more output from workers, which means that the stock market rises. On the other hand, the stock market could also affect productivity. As stock prices increase, productivity would also increase. According to a paper, stock prices forecast future productivity positively. The increase in the stock market reflects the greater value of capital and technologies, which are the determinants of productivity (Comin et al., 2016). The stock market and productivity are correlated with each other.

The coronavirus pandemic in 2020 caused the financial crisis and affected the stock market. During late February through March, the stock market crashed about 20% to 30%, which was the first major sign of recession. Because of the uncertainty due to the pandemic, the stock market made a lot of unprecedented swings. Debt has largely increased, and the economy around the world was going through economic stagnation. A lot of industries were closed, causing pressure on banks and a crash on the stock market. Stocks suffered the greatest fall during the pandemic in a lot of years.

Stock market prices can be driven psychologically. The “animal spirits” by John Maynard Keynes describe the psychological factors that affect how investors make financial decisions, which include buying or selling stocks during economic stress or uncertainty. When the spirit is high, the confidence in people is higher, so they are more optimistic. When the spirit is low, people get less confident, and they are more pessimistic. During the COVID-19 pandemic, people are pessimistic about the stock markets. However, when the news of vaccines came out, people became more optimistic about the stock markets. When investors buy overvalued assets and expect the prices to rise further, bubbles occur in the stock markets. Bubbles affect the stock markets with the rapid growth of prices. This change can cause fast inflation and a quick decrease in value.

Unemployment is affected by the condition of economics. When the economy of a country is in good condition, the unemployment rate will drop. When the economy is in poor condition, the unemployment rate will increase due to the scarcity of jobs. Unemployment is negatively correlated with the stock market. When there is a recession, unemployment increases, which causes the stock market to fall. When unemployment decreases, the stock will rise.

The monetary policy is the setting of the money supply by policymakers in the central bank. It directly affects the stock market. If the economy is in inflation and grows too fast, then the stock market will decrease because the central bank controlled the cash flow and influences interest rates. If the monetary policy lowers the interest rates due to the sluggish economy, then the stock market will rise. This is because the cost of borrowing is low, so firms can easily borrow money and hire more workers to increase production. Then, the stock market increases. The central bank takes control of the monetary policy during inflation or sluggish economy. They do so because they must keep the economy stable, so the monetary policy is directly correlated and affects the stock market.

Part 3: Conclusion

Among the factors listed above, the most crucial factors that affect the stock market are GDP, CPI, political events or news, productivity, “animal spirits”, and the monetary policy. GDP is important because it is the main indicator of a country’s economy. The CPI corrects economic variables for the effect of inflation. Political events and especially bad news cause the market to fall, and rise when there is good news. Productivity is one of the essential indicators of the stock market, and it is a country’s standard of living. The “animal spirit” shows the psychological impact on the stock market which is a critical factor. The monetary policy controls the stock market by influencing the interest rates and cash flow. These factors all have a significant impact on the stock markets.

Bibliography

Comin, Diego, et al. “Stock Price Fluctuations and Productivity Growth.” March 2016, https://events.barcelonagse.eu/live/files/1432-cgps316161pdf.

Duff, Victoria. “CPI Vs. Stock Prices.” CPI Vs. Stock Prices, https://finance.zacks.com/ cpi-vs-stock-prices-5166.html.

Hall, Mary. “How the Stock Market Affects GDP.” How the Stock Market Affects GDP, 2020, https://www.investopedia.com/ask/answers/033015/how-does-stock-market-affect- gross-domestic-product-gdp.asp.

Ioannidis, Christos, and Alexandros Kontonikas. “Monetary Policy and the Stock Market: Some International evidence.” Monetary policy and the stock market, 2006, https:// www.gla.ac.uk/media/Media_219105_smxx.pdf.

Kenton, Will. “Bubble.” Bubble Definition, 2020, https://www.investopedia.com/terms/b/ bubble.asp.

Preston, Chris. “The Unemployment-Stock Market Correlation in One Chart.” The Unemployment-Stock Market Correlation in One Chart, 2020, https://cabotwealth.com/ daily/stock-market/unemployment-stock-market-correlation-one-chart/.

Staff, Investopedia. “How Monetary Policy Affects Your Investments.” How Monetary Policy Affects Your Investments, 2021, https://www.investopedia.com/articles/investing/ 052813/how-monetary-policy-affects-your-investments.asp.

Tardi, Carla. “Animal Spirits.” Animal Spirits Definition, 2020, https:// www.investopedia.com/terms/a/animal-spirits.asp.


About the author

Xiaofei (Sophie) Sun

Sophie is a junior at The Ethel Walker School in Simbury, CT.