What Are Five Economic Factors That Affect Equity Returns?

Monitoring economic factors can help determine future equity returns.
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Ever wonder what causes your equity returns to fluctuate, often significantly? Economic factors almost always play a role, affecting your equity returns in the short and long term. Economic factors are broad-based circumstances that affect many people, who compose a market, and therefore affect the equity markets. Being aware of the economic factors that play a role in stock market performance can help you make more tactical decisions when it comes to equity purchases. While it is impossible to predict every gyration of an equity holding, by looking at economic factors you can form general conclusions on whether economic factors will inflate or deflate equity returns.

Interest Rates

The ability to borrow money is a driving force of the economy. Interest rates determine the cost of borrowing and can therefore have a significant impact on equity returns. If interest rates climb, it becomes unattractive to borrow and equities are likely to decline, followed by the overall economy. Declining interest rates are a positive sign for equity returns, although if interest rates decline too far it shows lack of economic demand and can lead to deflation. Lack of demand and deflation have a negative impact on equity returns.

Balance of Payments

The volume of international transactions significantly affects the economy of a country, and by extension the stock market within that country. A steady and consistent flow of money into the country for resources, goods and services means equities are likely to perform well. This is because when money is flowing it can be quickly utilized again within the economy, stimulating growth and further asset purchases. Inconsistent or poor demand (lack of money flow) means equities are likely to decline.

Government Policy

Trends in government spending and policy can impact the economy and equity returns. Through spending, governments can temporarily stabilize prices and employment, a phenomenon known as fiscal policy. This is intended to have a calming affect on investors and can temporarily boost equity prices. Increases in taxation, or a decrease in government spending, can have the opposite effect on equity prices. These action are more typically viewed as negative and can lead to declining equity returns.

Intermarket Relationships

Equities are a part of a financial system in which multiple asset classes are traded. Because of this, commodities, currencies and bond prices (as well as other assets) can have a direct and indirect effect on equity returns. For example, equities often move higher with commodity prices during the initial phase of an uptrend, but if commodity prices continue to soar, it has a negative affect on equities. Stocks also typically follow bonds, although bonds reverse direction several months or more before stocks do, making the relationship hard to see at times. Therefore, rising bond prices are positive for equity returns, while falling bond prices usually indicate that stocks could begin to decline soon as well. At times these relationships may break down, and may reverse in a deflationary environment. It is important to analyze how the markets are acting in relation to each before you make trades based on intermarket relationships.

Supply and Demand

Traders and investors are constantly trying to determine if stocks are going to go higher or decline. Each of these investors makes trades based on different criteria and from an alternative perspective. These conflicting views create supply and demand relationships, across all time frames, which ultimately push equities higher or lower. If there is little interest in equities, an excess supply develops and prices drop as investors try to sell. When there is significant demand for equities, prices rise as investors try to outbid one another and refrain from selling.

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