Basics of Macroeconomics – 4

Please see part 3 here: http://www.kataneh.com/index.php/2018/04/25/basics-of-macroeconomics-3/

These series of articles are for those intelligent group of people whose expertise are not economics or finance, but are still interested to understand the impact of macroeconomic monetary and fiscal policies such as interest rates, taxes or spending on the overall course of economy, their businesses, their employers, investments and of course their daily life.Therefore, in these articles, I have knowingly avoided using economic and finance terms and jargon, as much as possible.

The impact of different macroeconomics monetary and fiscal policies on each other, economy and growth are complicated and may cause vicious, benign or virtuous cycles. It is like a polynomial equation with many different interactive factors and coefficients. Changing the value of each factor and each coefficient will not only generate a different result, but may even change the value of some other factors in that same equation! And of course, changing one factor may generate multiple or totally different results for different values of another factor.

Knowing all those facts, in this article, discussion is kept very simple and to the point. At any time, we focus on one causal impact of one factor only if ALL other factors are assumed to remain constant.

Part 4- Interest Rates and Stock Market Valuation

a- You can purchase a basket of groceries for $100 today, but in one year from today, the same basket of groceries may cost you $105, and in 10 years the same basket might cost you $120. This means that you expect the prices to inflate by 5% in 1 year but by 20% in ten years.

Now, if you decide to invest your $100, you would want an investment that grows by 5% or better in one year, and by 20% in ten years.

This means that the higher the expected inflation is, the higher the growth should be to convince you to invest.

So, (as we learned in part 1), the higher the inflation is, the higher the interest rates will be, and therefore the higher the growth of a stock (or asset) should be to become an attractive investment.

It can be simply calculated as The Present Value of the Future Cash in n years = The Future Value divided by (1+interest rates)^n

Or, The Present Value of the Future Growth in n years = The Future Growth divided by (1+interest rates)^n.

In other words, the higher the interest rate is, the higher the future growth should be to convince you to invest.

b- Value of stocks are mainly based on how much money a company can make, or their earnings. Then for each sector and for each type of business stock price is a multiple of company’s earnings. For example in high tech sector, valuations are typically high and sometimes hundreds of times higher than the earning of the company. In some other sectors such as utilities, valuations are modest. But in average, the current price to earnings multiple of S&P500 (the index of 500 biggest US companies) is almost 25.

There is also a multiple called price to forward earnings. The price of the stock is determined based on the FUTURE earnings of the company.

Now the present value of future earnings is Future Earnings / (1+Interest Rate)^n. If interest rate goes up, the present value of future earnings goes down. Therefore in P/E (price to earning) valuation, price will have to go down, or else valuation will be too high.

In other words, as interest rates increase, -if growth in earning does not match or exceed the rate-, the stock price will diminish.

Summary of parts 1, 2, 3 and 4:

Lower interest rates cause price inflation. To tame inflation interest rates should increase.

Higher interest rates encourage savings and limit spending. The higher the interest rates are the more interest banks pay on people’s savings.

The higher the interest rate is, the higher the value of the currency is, and therefore exports will decrease, but imports increase.

Inflation might happen because of higher purchasing power, but may also happen because of limited supply. The latter case might have adverse consequences.

As interest rates rise with inflation, stock prices decline, because of the dependency of market valuation to interest rates.