You have probably heard that as stock prices go down, the gold price rises. It may be true, or it may not be. However, there is a connection between the two of them indeed.
In fact, there is a connection between stock markets and four other factors – commodity, as in precious metals, crude oil, etc; currency, i.e., dollar, pound, and rupees; interest rates, as in the rate of interest of lending and borrowing governed by the central bank; and inflation.
The thing is, macroeconomics is a major influencer of stock markets. On its own, a stock may seem to be free from the economic repercussions of a country. However, if you zoom out the picture, you realize that the economic policies of the home country, the actions of other countries, and global trade policies, all these things impact our stock markets and the other four factors.
What is this phenomenon?
The four factors correlate with each other, and influence each other, in a myriad of ways.
The interest rates are governed by the central bank, i.e., the RBI in India. The central bank has the responsibility to maintain a healthy level of inflation in the country so that the cost of living remains feasible for the general population. Inflation should not be too low either. If inflation is too low, the economy might be in danger of falling into deflation, which means prices and wages will fall - a phenomenon associated with very weak economic conditions.
The RBI maintains the inflation levels by employing monetary policy tools such as repo rates, reverse repo rates, etc. Thus, by increasing or decreasing the interest rates, RBI controls the inflow/outflow of money. Decreasing the interest rates makes people save less, and spend more. Therefore, the demand for goods and services increases, making prices, and inflation rise. Interest rates and inflation tend to have an inverse relationship.
Decreasing the interest rates usually decreases the value of the country’s currency. Lower interest rates make our economy less attractive to foreign investors, resulting in a higher outflow of money from our country. This lowers the demand and value of our currency.
When inflation levels rise, prices rise, and people want to hedge their portfolios against that risk. As the demand for goods and services increases, the prices of the goods and services also increase. And so does the prices of the commodities used to produce those goods and services. That is why commodities are also called portfolio hedges. Commodity prices tend to move in the same direction as inflation.
Finally, rising inflation levels tending to rising prices may lead to high volatility in stock markets. The individual company costs rise, revenue growth seems uncertain, and all this causes a company’s stock prices to fall. Lower interest rates prevail during rising inflation levels, which entices investors to leave the bond markets and invest in equities, which again, contributes to the market volatility. However, one way to beat inflation is to actually invest in stocks, since they also act as a hedge against rising prices. Over the long term, equities have consistently beaten inflation for a long time.
Thus, interest rates, inflation, currency exchange rates, and commodity prices, all influence the stock markets, and as someone said –
“The stock market is a leading indicator of where the economy will be in the not-too-distant future.”
Understanding the relationship between these factors is of utmost importance as an investor, so that you invest in the right stocks at the right time, and create wealth for yourself.
Happy Investing!
- Vaishali Patwa