• The importance of the relationship between the stock market and macroeconomic variables are important

• Many empirical studies in general conclude that the macroeconomic variables play a major role in influencing the stock return

• Macroeconomic variables are good indicators to make predictions on stock market movements

• We examine the response of the Malaysian stock market on selected macroeconomic variables using the ARDL bounds test

Equity prices, considered as the most firmly watched prices of companies’ assets, can easily fluctuate throughout trading days as they are very susceptible to changes in the stock market. Factors such as high volatility or irregular developments can cause adverse implications for the economy while uncontrolled volatility may keep the smooth working of financial market and unfavourably influence the performance of the economy. Stock market volatility rises during financial crisis and causes stock prices to plunge especially in developing markets.

Understanding the empirical relationship between the macroeconomic variables as explanatory factors in the variation of stock market performance can be very useful to the market practitioners and policy makers. In fact, the importance of the relationship between the stock market and macroeconomic variables are important and was clearly illustrated by previous studies either from a theoretical or empirical perspective. In general, the value of the shares depends on the psychology of investors as the investors cannot predict the movement of stock prices in present or in future based on historical (past) stock price only. Since the stock prices is a fast-moving variable, therefore understanding the relationship between stock prices and macroeconomic factors is necessary to the market participant in managing their investment portfolio, in terms of the risk and return relationship. This due to the fact that, any information in the market will be observed immediately in the market, and therefore it is expected that the movement of stock prices is very sensitive to the market news. There have been a significant number of empirical studies that modelled the relationship between stock market performance and real economic activities such as money supply, exchange rate, interest rate and inflation.

The behaviour of the stock market can be traced back by two competing theories in portfolio analysis namely Markowitz mean-variance analysis and the capital market model. Markowitz proposed the mean-variance analysis in explaining the risk and return relationship of the portfolio. Generally, there are two types of risk namely unsystematic and systematic risk in holding the asset. The unsystematic risk can be removed by diversification, whereas the systematic risk cannot be removed by diversification. In contrast, Sharpe have developed the capital asset pricing model (CAPM) in understanding the behaviour of the security return and argued that the market risk is the sole factor in explaining the security return, in which the sensitivity of the security return to market return is shown by the Beta. Since then, the financial economist has extended the capital market model because the market return itself is not enough in explaining the behaviour of the equity return.

Many empirical studies in examining the determinants of equity return have been done in the developed and emerging stock market, and the results in general conclude that the macroeconomic variables play a major role in influencing the stock return. In Malaysia context, most of the previous study in modelling the determinants of the stock price has used macro-level data and in general, the results found that there is a co-movement or long run relationship between economic activity and the stock market. This finding signal that the macroeconomic indicators are the main factor that can influence the performance of the stock market.

Investors generally believe that macroeconomic activities give a large impact to the volatility of the stock prices. Macroeconomic determinants can be a yardstick to the investors to forecast the performance of the stock market, as well as a perfect alternative to get additional information about the behaviour of the stock market. This is due to the nature of the stock markets that tend to be sensitive to circumstances like the transition level of economic activities. The nature of macroeconomic forces does provide some significant positive as well as negative effect, on the stock market performance reflected from the behaviour of the variable itself.

Other than financial variables, macroeconomic variables such as interest-rate term structures, inflation rates and money supply are good indicators to make predictions on stock market movements because they affect future consumption and investment. Hence, these variables are commonly used to predict future economic events that may affect the stock market. If stock returns can be predicted by macroeconomic variables which are publicly available, then investment decisions can be made by utilising past macroeconomic information. This exploitable opportunity would benefit market participants in formulating market-timing strategies. Meanwhile, macroeconomic variables selected to predict stock market movements often differ slightly across studies but traditional macroeconomic variables that are often selected are interest rates, inflation rates, money supply and industrial production.

The capitalisation of the Malaysian stock market has expanded and reached RM1.13 trillion as at end-Mar 2018 from RM0.8 trillion in 2010. The average trading activity also rose in 2018 with a daily average trading volume of 108.1 million units and trading value of RM956.6 million. The Malaysian domestic stock prices were relatively resilient although there were uncertainties in the global financial market. With stable growth in the past few years, the Malaysian stock market is expected to play a major role in a global financial market, thus providing an attractive investment opportunity for foreign investors. However, fundamental investors will not invest without looking at all the macroeconomic variables that influence the country's economic development to forecast future trends of stock returns and invest accordingly.

This study examines the response of the Malaysian stock market on selected macroeconomic variables, namely industrial production, inflation, money supply, interest rate and exchange rate over the period 2010 to 2018 (end-March). By using the autoregressive distributed lag (ARDL) bounds test, this study documented the presence of a long-run relationship between the performance of the stock indices in FBMKLCI and FBMSH as well as indices of selected sectors such as plantation, finance, consumer and industrial production and economic activity. We believe that the macroeconomic variables used here are reflective of the general economic and financial status of Malaysia.

Source: BIMB Securities Research - 13 Jul 2018