Money Supply Growth and stock market performance

SS 6 Reading 24 LOS b These parts are from Schweser Study Notes: “As the money supply increases, the economy generally expands. As the money supply increases, stock returns increase. Generally, inflation adversely affects the aggregate stock market.” My problem with these statements is the correlation between Money Supply growth and Inflation. Furthermore, for the effect of money supply growth to be understood,the reason for the money supply growth should be understood. Money supply growth which exceeds the GDP growth will most likely to reflect as inflation. Thus, it will negatively effect the aggregate stock market. (My view, with my meager economics knowledge) For example, how would you interpret if the Central Bank declares that M2 growth was almost 30% for the last year, while GDP growth was around 11% and inflation (CPI) was less than 5% for the same period? (some what a real case, with a currency pegged to U.S. Dollar) Any comments???

I haven’t gone over the economics material in L3, but from my understanding of economics, statement 1 should read “As the economy expands, the money supply generally increases.” This is the reverse of what was written, which has the causality reversed. The size of the money supply is mostly under the control of the central bank, who generally tries to increase the money supply in line with real GDP growth to reduce the chance of deflation (which is often considered worse than mild inflation because it reduces the incentive to invest at all). However, if the central bank overshoots the money supply, you start to get inflation, which is generally bad for any businesses that have elastic demand curves for their products (so it’s not quite so bad for food producers, but is bad for high-end automobiles). My guess is that most returns decrease in inflationary environments because most products and services have some elasticity to them, and top line revenues start to drop as consumers and industries start to have less discretionary income. If you have hyperinflation, then things really go to hell because it becomes almost impossible to project prices and revenues into the future. This raises the risk on all assets and therefore makes the prices fall to reflect that additional uncertainty. That leaves: “As money supply increases, stock returns increase.” I’m not sure about this one and will have to get to the material again. This is probably a short-run/long-run distinction. On the one hand, if money supply increases when the economy is growing and stock returns increase when the economy is growing, then there may be some spurious correlation between an increased money supply and increased stock returns that has nothing to do with money causing better returns. There may be a partial causal relationship in the short term in which additional money in the system causes people to look for places to invest it, driving up stock prices and resulting in higher total returns until people have parked that money. However, this would be a short term effect, since the long term effect of additional money looking for investment returns is to lower yields (assuming things like productivity stay constant or as expected), and therefore only the investors who got into the market early in the cycle would see a short term spike in returns as others buy into the same securities later.

Inflation sucks for the economy and for companies, it depresses real returns (which is a huge effect), company’s can’t typically push inflation 100% off to their customers and most likely will get hit harder on the expense and financing end by it (higher expenses and interest charges etc); this will blow their bottom end to hell. The longer term effect will be a depreciation in the currency, which should help the economy if the country is a heavy exporter, but this effect will be lagged until a long term inflationary estimate can be agreed upon by market participants. Economic growth is usually based upon endogenous factors and an economy in equilibrium will require the central bank to expand money supply by the amount of GDP growth. Dumping too much money in the system will have inflationary effects, that will have a lagged appearance, of at least a couple quarters if my memory serves me correctly, the scenario you laid out an inflationary appearance will definitely work it little way into the markets soon enough.

Thank you both. Actually the case I mentioned is a real case only that figures are not for last year, they are for 2007 for the first 8 months. Of course, inflation figures are some what dubious. As in many emerging markets, here as well, economic data is not aplenty and where it is available reliability and accuracy is sometimes questionable. IMF repeatedly urges authorities to improve economic statistics, particularly the ones related to inflation. (I do not know the particulars of the issue.) Furthermore, inflation is something very difficult (I, mean more difficult) to admit in this part of the world. Accelarating inflation is a new concept for this geography and it wouldn’t be wrong to say that masses feel the pinch of loss of purchasing power for the first time.

In early stages of business cycle, money supply generally increases as the central bank provides an impetus for the economy to accelerate from its recessionary slumber. In this phase, stock market rises as expectations of increased profitability take root. In the latter part of the business cycle, inflationary trends set in and the central bank becomes poised to decrease the money supply. Again market anticipates this and stock prices head south.

I think CFAAtlanta is correct: money expansion, economic expansion and market returns don’t necessarily happen concurrently. If I remember correctly, the Fed puts money into the system by buying treasuries in the open market, thereby decreasing yields. Cheaper borrowing costs allows banks to lend more, so money is easier to obtain to finance expansion of the real economy (productive capacity). When there is slack in the real economy (i.e. excess capacity in a recession) then this can happen without inflationary pressure. This is especially true for wage inflation, since firms generally run lean early in an expansion. They rely on productivity growth for as long as they can and usually only hire when the expansion is well on its way. The last U.S. expansion is a perfect example – many called it “the jobless recovery”. So while there’s a lagged correlation between money expansion and market returns, one does not cause the other. For example if the Fed continued to put liquidity into the system late after the real economy reaches capacity, then you get too much inflationary pressure particularly wage pressure, which hurts profit expectations and is also a disincentive for firms to expand – hence negative effect on market returns. The fundamental driver of market returns is expected future (real) profit growth. Money expansion is only indirectly correlated with this driver early in the expansionary cycle.

Hey CFAAtlanta, great to see you again. You took a vacation from AF?

how about asset inflation? can’t it just be that money is too easy to get and people borrow and invest in stock markets, real estates, etc.

VeryCool Wrote: ------------------------------------------------------- > how about asset inflation? > > can’t it just be that money is too easy to get and > people borrow and invest in stock markets, real > estates, etc. good point. In the U.S. I don’t think the Fed officially targets asset prices the way it “targets” general prices, and there’s more and more debate around this issue as a result of the recent real estate bubble. I suppose asset price inflation can come earlier in the cycle than general inflation, which would coincide with money expansion. And you could definitely argue that market returns would then be “driven” by cheap money. But I think you still need the expectation strong fundamentals in the future. If you’re a leveraged investor, just don’t get caught holding the bag if an expansion doesn’t materialize or if the s*** hits the fan :slight_smile: