Economic factors affect corporate profits, which influence stock prices and equity returns. Revenues depend on consumer and business spending, which vary with interest rates, employment and global economic conditions. Operating and non-operating expenses depend on interest rates, labor wage rates and commodity prices. Economic growth and low inflation usually mean positive equity returns, while recessions and high interest rates mean flat or negative returns.
The U.S. Federal Reserve sets short-term interest rates, which affect loans, credit cards and mortgages. The Fed lowers rates to spur economic growth and raises rates to control inflation. Rising rates mean higher borrowing costs, which mean lower disposable income for individuals and less investment flexibility for businesses. This could lead to lower revenues and profit margins, which would reduce equity returns. Conversely, lower interest rates could mean more consumer and business spending, which would improve margins and equity returns.
Employment rates affect interest rates because jobs determine disposable income. When people do not have jobs, they are likely to spend only on the essentials. They are unlikely to spend on big-ticket items, such as cars and travel. While the consumer staples sector would fare well in such an economic downturn, the stock returns of other sectors would suffer. When unemployment levels are low and more people have jobs, demand would pick up for both essential and non-essential goods, which would lead to positive equity returns.
Changes in commodity prices affect cost of goods sold, operating expenses and profit margins. Rising prices for energy and raw materials mean higher production and transportation costs for many businesses, which face margin pressure. With the exception of utilities that can apply for rate increases from regulatory authorities, most businesses are usually unable to pass on higher input costs to consumers. Conversely, operating costs would fall with falling energy and other commodity prices, which would help equity returns.
Consumer and business spending directly affect top-line revenues, which would influence profit margins and stock prices. Consumers spend when they have confidence in their jobs and in the economic outlook. This benefits the stock returns of companies in most sectors. Businesses invest in new capital equipment and expand facilities, which would benefit construction companies and equipment suppliers. Markets react positively and investors benefit from higher stock prices. However, markets fall when consumer spending and business investments decline, which lead to lower margins and equity returns.
Global economic conditions affect equity returns because companies do business across borders. For example, a weak U.S. economy could affect the revenues and profit margins of Asian and European suppliers of U.S. companies. Similarly, a credit crisis in Europe could hurt revenues for American businesses with extensive European operations. Companies with operations in different countries can offset losses in one region with gains elsewhere. For example, economic strength in Asia could offset weakness in Europe, which could help maintain margins and stock prices.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.