Executive Summary
The Effect of Macroeconomic Variables on
Stock Prices in the European Union
Yorick Reinders – S3162176
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Participants in financial markets closely observe all information which could
potentially influence stock prices, with the goal of correctly determining the value of stocks. Investors, economists, and policymakers all try to predict the direction of stock prices in order to make profits, or steer the economy in a certain direction. Most investors focus on individual companies, economists are mainly focused on the overall economy, and policymakers are interested in deploying different tools in order to steer the market. All these types of market participants can make use of a model which relates macroeconomic fundamentals to stock prices.
Recently, there has also been some discussion about what appears to be a gap between macroeconomic fundamentals and the stock market. After the initial drop in stock prices due to the Corona crisis the stock market rebounded relatively quickly and in many countries has risen back up to levels set before the Corona crisis. Keeping in mind that the macro economy has clearly not fully recovered yet from the crisis, it is interesting to investigate the exact nature of the relationship between macroeconomic fundamentals and stock prices.
Further, most studies into the relationship between macroeconomic variables and stock prices have focused on emerging markets and large individual developed economies
(Wongbangpo & Sharma (2002), Horobet & Dumitrecu (2009), and Humpe & Macmillan (2009)). Little research has been done on European countries, and the research that has been conducted has either focused on few variables, few countries, or has not been conducted recently (Nasseh & Strauss (2000), and Peiró (2016)).
Keeping all of this in mind, this paper aims to study the relationship between some prominent macroeconomic fundamental variables and stock prices in the five largest European Union (EU) economies for the period 1999:12 – 2019:12. The macroeconomic variables include: the short-term interest rate, long-term interest rate, money supply, inflation rate, industrial production, and oil price. The EU countries which will be investigated are: France, Germany, Italy, the Netherlands, and Spain.
The contribution of this paper to the existing research will be twofold: First, this paper considers a large group of European countries which are part of one of the biggest trade blocs in the world. Second, this paper uses a very recent dataset which can be used to compare findings with that of older papers to see if dynamics in the relationship between the variables and stock prices have changed over time.
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In order to investigate the potential long-run relationship between the macroeconomic variables and stock prices, the Johansen multivariate cointegration test is used. This procedure is used for detecting cointegration and based on a vector error correction model (VECM). Cointegration analysis is the ideal tool to determine the relationship, since the time series that are used in this study are non-stationary and have time-varying means and variances. Hence, standard methods like ordinary least squares (OLS) are not appropriate.
Next, the Granger causality test is used to determine the short-run and long-run causal relations between stock prices and macroeconomic variables. These relations can then be used in conjunction with the established short-run and long-run relationships from the VECM to draw some conclusions about the nature of the relationship.
Then finally, innovation accounting analysis is used to examine the dynamics among the macroeconomic variables and stock prices. This analysis involves using impulse response functions (IRFs) and forecast error variance decompositions (FEVDs). This analysis can be used to analyse the response of stock prices to shocks to the macroeconomic variables.
Results from this study show little evidence of a short-run relationship between the macroeconomic variables and stock prices for most countries, however there is significant evidence for a long-run relationship. Generally speaking, in the short-run the short-term interest rate is found to be negatively related to stock prices, while the other macroeconomic variables have no significant effect. In the long-run, the short-term interest rate, inflation rate, and oil price are found to be negatively related to stock prices. Further, the effect of the money supply, industrial production and exchange rate on stock prices is mixed, while the long-term interest rate has no significant effect.
These results can be used to make predictions about the future direction of stock prices. It shows that for policymakers the most important tool to influence the economy is the short-term interest rate. Also, policies can be used to aim at a low and stable inflation rate. Further, keeping a close look at the oil price might be beneficial to make predictions about the direction of the economy in the long-run.
