3.1.8 Drivers of equity markets
The key drivers of equity markets are:
- the prevailing and expected level of economic activity, as measured by gross domestic product (GDP) growth, employment levels and movements in the real incomes of households
- the prevailing and expected level of price inflation
- the prevailing and expected level of interest rates
- the trends in and expectations of the financial performance – particularly profitability – of the firms whose shares comprise the equity markets.
In addition to these core drivers, other factors that impact on equity markets include:
- movements in exchange rates
- changes to taxation – particularly company profits and on dividends paid to shareholders
- changes to commodity prices – particularly oil and gas
- random non-financial events like wars and disease epidemics which are expected to impact on (global) economic activity.
These factors impact, to greater or lesser extents, on the financial performance and expected future performance of the companies whose shares comprise the equity indices that investments in shares are linked to. A slowdown in economic activity, perhaps reflected in a weakening in price inflation, can be expected to reduce sales and profits. Under these circumstances companies may be forced to reduce the dividends paid to shareholders or even pay no dividend at all. The attraction of holding shares, relative to other assets, is then reduced, exposing the risk of a fall in share prices. The reverse generally holds as well – growing economic activity and a pick-up (provided it is not excessive) in inflation are co-related to higher share prices as companies experience growing sales and profits.
The relationship between inflation and the performance of stock markets is complex and hotly debated by analysts. Modest inflation may be favourable to share prices but higher inflation rates raise the prospect that action will be taken to stem inflationary pressures by raising interest rates and depressing economic activity – a scenario which would not be good for share prices. The other factors listed above have a role too in driving share markets. Higher interest rates are bad news for equities as they presage a decline in economic activity – as do higher commodity prices. If exchange rates move adversely – particularly if the domestic currency strengthens against foreign currencies – then equities can be hit since export sales may be reduced.
In addition to these factors that generally influence share prices, investors should look at company-specific factors that affect individual share prices. These factors are linked to the financial performance of companies – their published and forecast sales and profits in particular. There may also be responses to issues that have caused reputational damage to a company.
In 2015, the UK equity market witnessed a fair degree of volatility, with share prices falling sharply in the third quarter of the year. This was largely a reaction to concerns about the prospects for economic growth given the slowdown being witnessed in the Chinese economy.
Who have been the financial winners and losers from the financial crisis – savers or borrowers? What factors have led to this outcome?
Borrowers have clearly benefited from rock-bottom interest rates on loans and mortgages – although those holding balances on credit cards and store cards might disagree. Savers have lost out with returns low in nominal terms and, between 2012 and 2014, negative in real terms once price inflation is taken into account.
This outcome seems unfair since excess debt was one of the background factors to the financial crisis of 2007/08, while savers are doing what governments regularly exhort them to do – saving money for the future and retirement. However, the harsh reality is that to facilitate a recovery from the financial crisis, both personal and corporate debts had to be made manageable to limit the risk of adverse knock-on effects on the economy. Making debts more manageable has meant ensuring they are cheap to service – hence the low interest rate policies seen in the UK and globally since 2008.