How Does the Stock Market Affect the Economy?

Investors need to know that the stock market valuations are analyzed on the prospects of the economy. The stock market always discounts past events and focuses on the future of the sector/company. 

For better understanding, analyze the scenario of March 2020. Then, the countries started imposing a lockdown because of Covid-19. Investors in the market knew that the economy of a country is going to be affected. And then, we witnessed a collapse in all the stock markets. The March 2020 crash was due to the uncertainty of the virus, thus, investors preferred pulling out money from stock markets and investing in safe havens such as bonds and gold. 

Also, newcomers in the financial markets should understand that the emerging economy’s stock markets attract more foreign investors than developed country’s stock markets. Why? Because of the growth potential of the economy. 

Moreover, emerging economies have the potential to add more and more entrants to the stock market. The trend is visible in the Indian stock markets. In India, the brokers are also focussing on opening more and more Demat and Trading accounts by providing free trading accounts, making intraday trading less costly and many more such offers are being provided. 

Economic Effects of The Stock Market

• Wealth Effect

If the market plummets, it will directly affect the wealth of the investors. Thus, leading to loss of purchasing power in the economy. Which then directly affects the economy with low demand and high supply, increasing the inflationary risks. 

• Business Investment 

The investment in the business is also affected if the wealth of the majority of investors is wiped off. It becomes difficult for the business to raise fresh loans as the stock market crash affects the bank’s lending power as well. 

In a bull market, stock prices continue to outperform, because of the investor’s confidence in the market. Also, companies prefer to launch online IPO in the bull market. As the optimism in the market is high during that time. 

Economic growth affects oppositely when the markets are bearish. The economy is affected adversely in the bear market as investors lose confidence in the market. Thus, during the bear market raising funds from the market becomes difficult. 

• Confidence

The emotions and psychology behind investing are very crucial in stock markets. When there is nervousness in the market, the stock markets always plummet. The same happened in the March of 2020 when the stock markets tumbled. 

However, as we already discussed, the equity/stock market always cares about the future. The market has the potential to outperform even when the economy is in recession. 

• Bond Market

The psychology behind investing states that correction/crash in one asset class, makes investing in another asset class look more attractive. Investors hate to lose their capital. Therefore, when the stock market is crashing, they book the profit from the equity market and prefer investing in the commodity or bond market. They guarantee sure-shot returns. 

• Other Factors

For instance, retired individuals earn a fixed monthly pension. They save some money from the pension and invest the amount in the stock market, to hedge against the inflation rate. Now, a sudden fall in the stock market will affect their investment value.

Therefore, leaving no other option but to save more money and spend less. Thus, affecting the spending power of an individual.  

Also, companies that save pension funds for their employees invest the fund amount in the stock market. Thus, when the stock market plummets, the saved-up pension fund for employees loses its value. Which then affects the earnings of a taxpayer. 

Also read:- What is the Grey Market Premium (GMP) in an IPO?