MACROECONOMIC UNCERTAINTIES & STOCK

MARKET PERFORMANCE: EVIDENCES FROM

EMERGING ECONOMIES
Synopsis
Anchal Agrawal (5C)

TABLE of CONTENTS
Motivation .......................................................................................................... 3
Importance of Understanding Uncertainty ............................................................................ 4
Stock Market Performances ................................................................................................... 5

Present State of Art ............................................................................................ 8

Objective .......................................................................................................... 10
Proposed Methodology .................................................................................... 10

Motivation
The world economy has been in a volatile state for quite a few years at a stretch now. Since mid
of 2008, there has been a large
number of adverse shocks for

GDP Growth Rates

15

which the world wasnt prepared.

This series of shocks started in

10

2008 with the sub-prime crisis in

the USA which gradually spread

EU
5

USA
World

to a number of other countries.

2012

2010

2008

2006

seemed like any other bad year

India

0
2004

The crisis and the year 2008

Russia

-5

for the world economy. But

unfortunately,

it

wasnt.

Economic integration, which is a

-10
Source: Data from World Bank

boon most of the times, proved to be essential in transmitting the strong ripples of this crisis
across the world. It triggered a severe slump in Europe which is yet to recover still. Emerging
markets which were heavily dependent on the developed economies of the West were the
ones which faced a lot of adversities and some are facing them still. The USA started to recover
in 2010, but it wasnt enough to lift up the rest of the world economy. What added to this
slump was the Sovereign debt crisis of EU. So it wasnt a normal economic cycle following its
usual path. The period of recovery faced a number of unprecedented shocks which prevented
normal growth after recession. As can be seen from the chart above, growth of the developed,
the developing and of the world as a whole faced a huge setback after 2008. It started to
recover somewhat post that, but then again in 2010 it started declining.
The unusual shocks, their nature and severities, have now forced companies and households to
start preparing for the large variety of paths that the economy can take. They have become
much more uncertain about the current and the future economic scenario. Increased levels of
uncertainty have had a negative effect on the World economy. People and companies are not
able to plan, they are not confident on their own forecasts, willingness to take risk has

decreased and so has ability to take it. Evidence of the same can be seen in spending patterns,
investment decisions, asset prices and policy choices. The rise in uncertainty has been a major
reason for the extremely slow recovery. Response to stimuli has become ineffective, and it has
become really important to study macroeconomic uncertainty as a subject in itself to
understand the impacts that it has on various markets. The impact needs to be seen in the
perspective of the developed and the emerging markets separately.
Importance of Understanding Uncertainty
All decisions, whether by households or by firms are made on the basis of the information
around them and their understanding of that information. The decisions could be about
development, spending, investments etc. The information generally used in such decision
making is future outlook of demand-supply growth, income growth, increase in prices and so
on. An element of uncertainty has already been captured through understanding and personal
judgments. Some underlying level of uncertainty always exists in an economy and it is mostly
on this uncertainty that companies and individuals play on in an attempt to gain an edge over
the others. But as uncertainty of the future changes over time, and that too quite frequently, it
becomes difficult to use the existing judgments. If one company is taken over by another, the
employees may feel more uncertain about whether next years pay will be higher or lower than
currently. Or businesses may become more unsure about the level of next years orders if there
is a change of government in one of their export markets.
Sector

Chanel

Description

Households

Precautionary

Households

savings

labour income and postpone

Wait and see

Firms

Economic

References

Consumption

Firms uncertain about future

Dixit and Pindyck

Investment

sales and profits postpone

(1994)

Productivity

and

about

affected

Carroll (1996)

production

unsure

variable

and

investment

until uncertainty is resolved

Firms

Entry and exit

Firms postpone entering new

Bloom

markets,

Disney, Haskell and

markets

including

export

(2009),

Heden (2003)

Productivity
exports

and

These firms are likely to be the

most productive
Firms

Labour

market

distortions

Households unwilling to search

Lazear and Spletzer

for more productive jobs, firms

(2011)

Productivity

unwilling to post vacancies so

the resulting matches are less
productive

All sectors

Financial

Uncertainty over future asset

Whaley

price

Gilchrist, Sim and

volatility

raises

risk

premia and the cost of credit

(2000),

Credit, consumption
and investment

Zakrajsek (2010)

to households and companies

Source: Macroeconomic uncertainty: what is it, how can we measure it and why does it matter?

Shocks to uncertainty affect economic activity through a number of channels. They affect the
level of demand for goods and services in the economy, via consumption and investment
decisions. But uncertainty can also have an impact on the supply side of the economy, by
affecting productivity growth or credit provision. It is important to consider how uncertainty
shocks affect these demand and supply channels because they have different implications for
activity and inflationary pressure. For example, if an increase in uncertainty reduces demand
but has no impact on supply it will tend to put downward pressure on inflation as a margin of
slack opens up in the economy. By contrast, if an increase in uncertainty also reduces supply, it
would lessen the amount of slack and downward pressure on inflation so monetary policy
makers might, other things equal, need to loosen policy less to maintain stable inflation.
Stock Market Performances
The stock market responds to various changes. These changes could be macroeconomic,
sentimental, and fundamental and so on and so forth. Macroeconomic parameters such as
inflation, growth, government and federal bank policies are lead or lagged by stock market
reflections in most cases. Stock market performance serves as a good proxy for measuring the
severity of shocks. Below are a couple of graphs plotted in the Indian context. Here stock
market performance represented by the NIFTY 50 index is compared with GDP growth rate and

WPI inflation percentage changes. In the first graph it can be seen to some extent that stock
market performance is leads changes in GDP. Of course, a whole year is too big a period for
monitoring stock markets, but the graph gives a fairly good idea about its correlation with GDP
growth. Same is with the second graph. Performance of NIFTY is almost consistent with the
changes in WPI.
India: NIFTY vs. GDP Growth
100
80
60
40
NIFTY (YoY)

20

GDP (YoY)

0
2004

-20

2005

2006

2007

2008

2009

2010

2011

2012

-40
-60
Source: NIFTY data from moneycontrol; GDP data from Bloomberg

India: NIFTY vs. WPI

40
30
20

-20
-30
Source: NIFTY data from moneycontrol; WPI data from Bloomberg

Mar-13

Sep-12

Mar-12

Sep-11

Mar-11

Sep-10

Mar-10

-10

Sep-09

WPI Monthly (YoY)

Mar-09

0
Sep-08

NIFTY Monthly (%)

Mar-08

10

So we can see that there is a correlation between a number of macroeconomic variables with
stock market performance and studies have also been done on the same.
What remains to be studied in detail is whether there is any correlation between
macroeconomic uncertainties and stock market performances. If yes, then what is the degree
to which they are correlated and how can this relationship be quantified. It is also important to
note that these relationships would be different in case of different economies developed and
developing.

Present State of Art

A significant literature exists which investigates the relationship between stock market returns
and a range of macroeconomic and financial variables, across a number of different stock
markets and over a range of different time horizons. Existing financial economic theory
provides a number of models that provide a framework for the study of this relationship. One
such theory is the Arbitrage Pricing theory (Ross 1976). This theory was proposed by Stephen
Ross in 1976. It states that the expected return of a financial asset can be modeled as a linear
function of various macroeconomic factors or theoretical market indices. Most of the empirical
studies based on APT theory, linking the state of the macro economy to stock market returns,
are characterized by modeling a short run relationship between macroeconomic variables and
the stock price in terms of first differences, assuming trend stationarity. There are a number of
relevant studies in this regard - Fama (1981, 1990), Fama and French (1989), Schwert (1990),
Ferson and Harvey (1991) and Black, Fraser and MacDonald (1997). In general, these papers
found a significant relationship between stock market returns and changes in macroeconomic
variables, such as industrial production, inflation, interest rates, the yield curve and a risk
premium. A research paper by Hump and Macmillan (2007) finds an empirical relationship
between industrial production, the consumer price index, money supply, long term interest
rates and stock prices in the US and Japan. It was seen that stock prices are positively related to
industrial production and negatively related to both the consumer price index and a long term
interest rate. It was also found that an insignificant positive relationship between US stock
prices and the money supply. Fama and and French in 1989 tried to present a coherent story
that related variation through time of expected returns on bonds and stocks to business
conditions. It was seen that the default spread is a business-conditions variable, high during
periods like the Great Depression when business is persistently poor and low during periods
when the economy is persistently strong. The dividend yield is correlated with the default
spread and moves in a similar way with long-term business conditions. The fact that the three
variables forecast stock and bond returns then suggests that the implied variation in expected
returns is largely common across securities, and is negatively related to long- and short-term
variation in business conditions. One story for these results is that when business conditions are

poor, income is low and expected returns on bonds and stocks must be high to induce
substitution from consumption to investment. When times are good and income is high, the
market clears at lower levels of expected returns.
Along with theories and studies to understand the relationship between Macroeconomic
variables and performance of capital markets there is also present some literature on
macroeconomic uncertainties and capital markets. An empirical study by Beber and Brandt
(2009) tries to develop a link between the ex-ante uncertainty about macroeconomic
fundamentals and the ex-post resolution of this uncertainty in the financial markets. They
measured macroeconomic uncertainty using prices of economic derivatives and relate this
measure to changes in implied volatilities of stock and bond options when the economic data is
released. Higher macroeconomic uncertainty is associated with greater reduction in implied
volatilities following the news release. It is also associated with increased volume and
decreased open interest in options market after the release, consistent with market
participants using financial options to hedge or speculate on macroeconomic news.
So there are a number of other models and empirical evidences that clearly derive a
relationship between macroeconomic variables and financial markets performance in general
and stock market performance in particular. A few researchers are coming up with developing
models and evidences for relating uncertainties to performance of financial markets. But there
is still a huge gap in terms of literature when it comes to the impact of uncertainties on the
performance of stock market especially in emerging economies.

Objective
After having studied the existing literature in the area of impact study of macroeconomic
uncertainties, it was seen that there is a gap in terms of studies based on stock markets of
emerging economies. On this basis, I would like to derive the objective of my study as follows
To complement existing literature to develop an understanding of the impact of
macroeconomic uncertainties on stock market performance in the context of emerging
markets.

Proposed Methodology
1. Finalizing on a proxy for quantifying uncertainties from the below mentioned optionsa. Economic Derivatives
b. Volatility of World Industrial Production Index
c. Innovations to one or more of five macroeconomic variables - inflation, growth,
the terms of trade, the real exchange rate and the price of capital goods
d. Annual and Quarterly Bank Level Data
e. Comparing forecasts and actual values of historical GDP
2. Extracting data for the proxy and for the stock market index for a period of 5-6 years
3. Establishing empirical link between the two data sets
4. Drawing a conclusion based upon the understanding of the linkage