Macroeconomic Influences and Equity Market Returns: A Study of an Emerging Equity Market

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INTRODUCTION

During last decade phenomenal growth has been observed in emerging equity markets and Pakistan is no exception. The KSE- 100 index, which is the benchmark for the Pakistani equity market, has exhibited unparalleled growth and moved from 921 in 2002 to over 16000 points. This remarkable growth has been a subject of global interest. During said period significant changes has also been observed in macroeconomic factors. An unprecedented change has also been observed in Interest rates, inflation, exchange rates, capital flows and Oil prices in the country. So question arises whether there exists a relationship among equity markets and macroeconomic factors.

The link among macroeconomic variables and the equity market has always attracted the curiosity of academicians and practitioners as it has an innate appeal. Finance theory suggests that prices of financial instruments are based on expected cash flows and discount factor. Macroeconomic variables affect both expected cash flows as well as discount rates. Therefore macroeconomic changes should be priced by market. The traditional dividend discount model is also based on above theoretical framework.

Therefore it is a well established fact that equity prices are influenced by economic information but theory is silent about specific variables which may influence equity prices. The empirical work has attempted to establish the relationship but results are yet inconclusive

Chen, Roll, and Ross (1986) explore this new avenue by examining the link among equity prices and macroeconomic variables by employing a multifactor model which provides evidence that macroeconomic factors are priced. Pearce and Roley (1985), Hardouvelis (1987), McElroy and Burmeister(1988), Hamao (1988) and Cutler, Potterba and Summers (1989) also confirm that equity prices react to arrival of macroeconomic information. At the same time, Poon and Taylor(1991), Shanken(1992) contradict the results. Some studies are in partial agreement. Flannery and Protopapadakis (2002) are of opinion that macroeconomic variables can predict future equity market returns to some extent and exact relationship among is difficult to establish. Therefore empirical evidence on relationship among macroeconomic variables and equity market is mixed

Under this cloud of uncertainty, number of studies has been conducted in various parts of globe by using various methods of exploring long term relationship among time series data. Mukherjee and Naka (1995), Cheung and Ng (1998), Nasseh and Strauss (2000), McMillan (2001) and Chaudhuri and Smiles (2004) employs cointegration analysis and granger causality test to explore long run relationship among equity prices and macroeconomic variables.

According to Humpe and Macmillan(2007) significant research has been done to investigate the relationship between equity market returns and a broad range of macroeconomic factors , across a number of equity markets and over a range of different time horizon. But this research is generally focused on developed markets or emerging markets of Asia Pacific Rim. Only few studies are available with reference to Pakistan which is one of the major countries of south Asia and lies on cross roads of Central Asia, Middle East. And these studies only explore few variables.

The objective of this paper is to analyze the long-term relationship between the KSE and a broad set of macroeconomic factors for a longer time period by employing conitegration approach proposed by Johnson and Jusilius. Direction of causal flow has been captured by using Granger causality test. Other dynamic of time series data have also been explored by using impulse response analysis and variance decomposition analysis. The broad set of macroeconomic variable include industrial production index , consumer price index, money supply , exchange rate, foreign portfolio investment, Treasury bill rates and oil prices. This set of data has been used first time in Pakistan. …