Chapter 5: Evaluation of significant fundamental determinants of the NZX 50 Index 67
5.2 Variable selection and expected relationship
It is impossible to conclude that the link between the macroeconomy and the financial market is precise and entirely in one direction. Stock market indices are reacting to some
macroeconomic forces; thus, they can act as endogenous. These macroeconomic variables are interconnected; therefore, it is difficult to determine the exclusive impact of the individual macroeconomic variable on the stock market index, although their combined effect can be determined. Only random factors such as earthquakes, pandemics, and terrorist actions are exogenous to financial markets.
Four macroeconomic variables, namely New Zealand’s exchange rate, interest rate, inflation rate, and foreign stock market Index (S&P 500), were chosen to evaluate their influences and the directions on the NZX 50 Index. This section briefly examines the expected theoretical relationships between each macroeconomic variable with the stock market and provides evidence of selected empirical findings.
5.2.1 Relationship between exchange rate and stock market
The literature on the theoretical underpinning of the relationship between FOREX and the stock market can be broadly divided into the international trading effect and the portfolio balance effect. The international trading effect suggests that currency depreciation will positively (negatively) impact export (import) based companies and thus will increase (decrease) their stocks. On the other hand, the portfolio balance effect postulates an influx of foreign capital inflow to a solid and well-performing country, thus, influencing that country's stock market to go up, causing the currency to appreciate. The existing literature provides contrasting empirical evidence on the relationship between the exchange rate and the stock market. For example, [262] and [263] found a positive relationship between stock market prices and exchange rates.
However, [264]–[266] identified a negative association between exchange rate and stock market performance. The contrasting findings are due to the complexities inherent within the interconnected macroeconomic variables, economic and political diversities, differences in the
capital market integration, variations in time horizons, time frequencies, real versus nominal values, and so forth.
5.2.2 Relationship between interest rate and stock market
It is expected that there is a negative relationship between interest rate and investments in the stock market. The interest rate can be viewed as a borrowing rate from the borrowers’ point of view, but it can also be considered a lending rate from the lenders’ point of view. Therefore, the rising interest rate influences the banks to pay more rewards to the bank depositors, thereby influencing the investors to switch the capital from the share market to the banks. Similarly, rising interest rates affect the lending rates to increase, which hurts investments in general. In a nutshell, there is an inverse relationship between stock market investments and interest rates.
However, the literature provides conflicting conclusions about the relationship between interest rate and the stock market. For example, [78], [267], [268] et al. found a negative association between interest rate and stock return. However, [269], [270] et al. observed a positive association between interest rate and stock return. These conflicting conclusions are primarily due to the complexities inherent within the analysed macroeconomic variables, variations in time horizons, time frequencies, real versus nominal values, the presence of political and economic diversities, and so on.
5.2.3 Relationship between inflation rate and stock market
Inflation, the rise in the general level of prices of goods and services, affects the purchasing power of the currency (in that country) to fall. The relationship between inflation on the stock market has been examined worldwide at different periods, and the literature provides inconsistent empirical findings. Based on Fisher’s [271], [272] hypothesis, a positive relationship between inflation and stock returns is expected as investing in stocks can be a good hedging strategy to mitigate inflation. In this vein, [268] and [273] empirically found a positive
relationship between inflation and stock returns. However, [38], [274]–[281] and the like observed a solid negative relationship between stock returns and inflation. The intricacies inherent in the interconnectedness of the macroeconomic variables, economic and political multiplicities, diversities in the capital market integration, variations in time horizons, and so on can be attributed to the differences in these conclusions.
5.2.4 Relationship between a key foreign stock market and a selected stock market in a small economy
The flow of international capital is becoming significant in recent years; this is generally attributed to the expansion in global operations of prominent corporations, sophistication in Information Technology and computer systems, relaxation of controls on capital movements, etc. Substantial research has been conducted to test the interrelationship between stock market linkages. For example, [282]–[285] concluded the strong interconnection amongst national stock markets. [286] evaluated the effects of co-movement between the stock returns of Portugal (a small open economy) and the United States (a larger economy). They found that the Portuguese stock market reacted to the US macroeconomic news.
New Zealand is a small open economy like Portugal, and we consider the sensitivity of its stock market to the global macroeconomic factors. Additionally, [78] examined the relationship between the NZSE 40 Index (the benchmark index before forming the NZX 50 Index) and a set of macroeconomic variables. [78] suggested that future researchers integrate global macroeconomic factors to capture the New Zealand stock market's sensitivity to the global macroeconomic factors. Considering these factors and directions, the Standard & Poor’s 500 (S&P 500) Index, widely regarded as the best single gauge of large-cap US equities, is used to capture the effects of a major international stock market news on the NZX 50 Index.