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

Article excerpt


This study examines the short run and long run causal relationships among macroeconomic variables and equity market returns in the emerging equity market for the period of 6/1998 to 6/2008 by employing the VAR framework on monthly data. Macroeconomic variables include industrial production index, consumer price index, money supply, exchange rate, foreign portfolio investment, Treasury bill rates and oil prices. Results support the finance theory and provide evidence that long term relationship exist among equity market and macroeconomic factors. Unidirectional causality has been observed flowing from consumer price index, exchange rates, money supply and interest rate to equity market. No granger causality is observed among industrial production, foreign portfolio investment and equity market returns. This insignificant relationship with industrial production, oil indicates that market movement is not based on fundamentals and real economic activity. The cointegration analysis only captures the long-run relationship among the variables, it does not provideinformation on responsiveness of equity market returns to shocks in macroeconomic variables so impulse response function and Variance decomposition analysis based on VECM has also been performed. Variance decomposition analysis also confirms that monetary variables are a significant source of volatility in equity market.


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. …