Do Government Policies Impact Stock Markets?

There are very many variables that impact stock prices. However, the government fiscal policy which is announced in the annual budget every year and the monetary policy announced by the Reserve Bank of India have a special significance not only on overall economic growth and stability but also on the equity prices. Geyatee Deshpande analyses the connection and impact of both these policies on the equity prices

The Union Budget is always considered a major event that decides the market direction at least in the short to medium term. Considering that the budget is an annual event, every stakeholder has to take cognizance of it and use it to frame investment decisions for the year ahead. The announcements made during the budget are, after all, connected to the fiscal policy and discuss at length how much money is going to be spent to support the demand side of the economy. A fiscal policy is essential to keep the economic growth engine on track. In fact, a fiscal policy has the dual objective of maintaining steady economic growth as well as social justice by taxing the rich and subsidising the poor. 

Fiscal Policy

The fiscal policy thus is very important from the stock market point of view. Taxation is something that is decided in the fiscal policy and subsidies are announced to provide support to any particular sector that is struggling to survive. On most occasions, import duties and export duties are tinkered with in the fiscal policy in order to support a particular sector and also to strike a balance between exports and imports. Basically, the fiscal policy aims to increase aggregate demand in the country. 

Aggregate demand is a derivative of the consumption level in the country, government spending, investments, and net exports and imports.

The formula below explains how to calculate the aggregate demand: AD = C+G+I+ (X-M) Aggregate Demand = Consumption + Government Spending + Investments + (Exports – Imports). 

The objective of any government is to increase the aggregate demand level in the country. When the aggregate demand increases there is heightened demand for goods and services as the economy grows at a faster pace. Equity prices in the long term definitely stand to gain with rising aggregate demand in any country. However, the relation is not linear as it is not always easy to ascertain if the markets will inch up whenever the government announces fiscal measures that could increase the aggregate demand levels. In its fiscal policy the government may, for example, decide to subsidise PSU banks, the fertiliser sector or the agriculture sector and may provide tax benefits to certain sectors such as realty and infrastructure to promote an increase in investments.

While these steps are desirable and important in the long run, the stock market pose some of the most difficult questions such as: How is the whole operation being funded and at what costs? Will the fiscal deficit increase due to funding of the expansionary budget? The market can remain exuberant due to expansionary fiscal policies or it can get really concerned on the deficit front and may conclude that due to excessive loans the overall economic growth may be impacted negatively. While an expansionary fiscal policy can be great for the equity markets, it is not guaranteed that such policies that seemingly are good for overall economic growth in the long term may push equity prices higher in the short to medium term. As such, the fiscal policy is a complex animal that may impact the fortunes of the market in an obscure manner. However, the impact of monetary policy decisions on stock prices can be instant and relatively easily calculable.

Monetary Policy

The aim and objective of any monetary policy is to:

✓Manage money supply in the economy 
✓Manage the rate of money i.e. interest rates 
✓Control inflation.

With these objectives the aim of any monetary policy is to facilitate economic growth and provide stability in terms of prices of essential commodities, also known as inflation. Interest rate management and inflation management is a delicate task undertaken by the Reserve Bank of India (RBI). The decisions taken by the RBI on both the interest rate front and inflation front have a direct impact on the stock prices. With tampering of interest rates, various corporates’ earnings per share (EPS) are impacted due to their debts on books. When the interest rates are lowered, the EPS increases as the interest outflow decreases. Stock markets move not only based on policy decisions but also on the expectation hinging on the interest rate front. For example, when the market synthesizes the inflation data, it attempts to speculate on the monetary policy decisions and decides on the direction it has to take.

If inflation is very high there is always a chance that the policymaker will not cut the interest rates, if not increase the interest rates. The market always wants to know more on the interest rate outlook and ascertain whether the stance adopted by the central bank is hawkish or dovish. A hawkish stance would mean that the policymakers want to curb excessive inflation and there is a chance of rising interest rates. Such an outlook may not always be in favour of the equity markets. On the contrary, a dovish view by the policymakers suggests that there is little fear of inflationary pressures and the interest rates could be reduced further. Such an outlook is great for equity returns as lower interest rates may improve the bottom-line of listed companies. 

Conclusion

It is extremely important that investors keep a tab on government policies as the policies announced directly or indirectly impact the health of the stock market. The monetary policy, it is found, has an immediate effect on the stock prices and time and again the lowering interest rate scenario has proven to push the equity prices higher. At the same time, when the interest rate environment is soft and the government announces an expansionary fiscal policy, there is a good chance that the aggregate demand or economic activity will increase rapidly. Such a spurt in economic activity aided with ample liquidity may lead to rising commodity prices and thus higher inflation. With higher inflation there is always a chance of interest rates being hiked. With money getting costlier, economic activity may slow down. Equity prices thus tend to take cues from economic developments which are influenced by the government policies. Proactive monetary policy in times of any crisis situation has proven to be a boon for equity prices. The near zero interest rates have got many investors with loads of money chasing a limited number of quality stocks. Such an environment can lead to a liquidity-driven market rally which may not always sustain on its own unless supported by earnings’ growth. But as the interest rates are artificially kept near zero or as low as possible, the bottom-line improves for a majority of listed companies. 

At such a time, the earnings tend to show some improvement even when there is no sustained increase in the demand for the products and services offered by companies. It is worth noting that in scenarios where the interest rates are declining, it is the interest rate-sensitive stocks that tend to outperform the markets. While a rate cut is a macro event and does impact the whole economy and affects all the companies, a rate cut has special significance for rate-sensitive stocks. Banks, financials and non-banking financial companies of the world will stand to benefit directly from any such rate cuts and so also the automotive companies. As the cost of money goes down, the purchasing ability of the consumer goes up and there is more demand for such high-ticket products.

Even real estate stocks tend to gain as interest rates show a downward trajectory. As investors, what is crucial to remember is that an expansionary fiscal policy may not always bring cheers to the market but an aggressive monetary policy that reduces the interest rates may push equity prices higher 100 per cent of the times. It is interest rate-sensitive stocks one should aim at investing in when the interest rate environment is soft. That said, a soft interest rate environment is conducive to the overall markets. Accurate reading of the government policies, its contours and the possible impact of such government policies – both fiscal and monetary – should therefore be taken into consideration by a prudent long-term investor.