How do News Effect Financial Market - Essay Example

 Table of Contents Introduction 4 How Macro-economic News Affects Financial Markets 5 How News regarding Inflation Affects Financial Markets 6 How News Regarding GDP Affects Financial Markets 8 How News Regarding Oil Crude Prices Affects Financial Markets 10 How News Regarding Unemployment Affects Financial Markets 10 How News Regarding Taxation Affects Financial Markets 12 How the Financial Markets React to News Regarding Natural Disasters 12 How Financial Markets React to Global Crisis 16 How News Regarding Corporate Scandals Affects Financial Markets 20 How News Regarding Merger & Acquisitions Affects Financial Markets 22 Conclusion 23 References 24 Appendix 26 Regression Models to Understand How News Affects Financial Markets 26 Introduction News headlines are periodically reviewed by both the long term investors and the short term investors since news affects stock price movements. News which affects the financial markets may be categorised into positive news, negative news and indifferent news. Positive news is that news which influences the market participants to react positively and an overall upward trend in the financial markets is created from positive news. Negative news influences the investors to react negatively and pullout money from the market. While the former represents optimistic views about future stock price movements, the later is the pessimistic view of market participants about the financial markets. The third category of news are those to which the market participants are indifferent and do not react at all. A market speculator is always smart enough to decode market news and takes advantage of price movement trends. Positive news tends to create positive trends in stock markets and due to this reason the share prices seem to rise soon after any positive news is available in the financial markets. Examples of positive news includes, higher GDP numbers for the following quarters, joint venture agreements, discovery of oil reserves, above expected financial results, company securing new clients, and so on. But sometimes it can also be seen that the markets close low after positive news. One of the reasons behind such reactions is market speculations and rumours. The financial market participants anticipate new stories and reacts accordingly. If there are rumours in the market, the investor may act surprisingly and the stock prices may experience temporary drop even after positive news. This is the reason as to why all market participants keep close watch on market related news and investment headlines. Keeping updated with latest news helps investors understand how the news headlines affect the financial markets. The negative news has far reaching affects on the investor sentiments and financial markets compared to positive news. It is often seen that when there is slightest bit of bothersome among the market participants, the stock markets crashes. Such negative news includes company involved in fraudulent practices, insider trading, economic disasters, unemployment, and so on. How Macro-economic News Affects Financial Markets The financial market reacts almost immediately to the external macro-economic events and influences the financial performances of companies. Whenever important news regarding any relevant macro-economic factors (like oil prices, inflation, unemployment, Eurozone Crisis, scandals, etc.) reaches the financial markets, the immediate reaction is reflected in the stock prices of securities. This happens due to the panic of the investors which may drive them to either pull out money from market or put money in stocks. For instance, the stock market prices generally move in opposite direction to oil price movements. So, whenever the oil prices go up, the stock markets declines and vice-versa (Kilian, 2007, pp.31-32). Some other important external macro economic factors which influence stock price movements are discussed in this paper. Again, the interest rates and exchange rate movements also influence stock prices. Based on the rise in domestic rates the capital inflows and appreciation of domestic currency is determined. This means that countries such as China which is mostly export driven economy, appreciation of currency will negatively impact its financial markets. This is because, appreciation of currency makes the imports cheaper for domestic country and exports costlier for foreign countries due to high prevailing domestic rates. Thus, importing economies look for news regarding higher rates announcement by the government in future while exporting countries look for lower rates announcements. The financial markets including stock exchanges act as the most important market to promote economic development by proper balancing of demand and supply in the markets. The impacts of news regarding macroeconomic factors affecting the stock markets may have long term effect depending on the future expectation of the market participants. The individual expectation of few or a group of investors does not constitute a market. The term expectation implies the sum total or aggregate market expectation created from a combination of macro factors and triggered by global and local news. How News regarding Inflation Affects Financial Markets High inflation increases value of assets but depreciates the assets’ book value. Schwert and Fama found evidence that inflation lowers share prices and hence at times of inflation the stock prices moves down (Pearce, 1982, pp.6-9). The impact of inflation on stock price movements was studied first by great economist Irving Fisher. His studies revealed that during high inflation the cash flows from shares rise due to selling pressure in market but investor expectation is independent of inflation. Economist of University of Washington, Prof. Charles Nelson studied the impact of inflation on stock prices and concluded that stocks should be bought when inflation is low and stocks should be sold when inflation is high. The stock market generally reacts to significant changes in inflation over a period of time. Whenever the inflation rises, the government hikes the interest rates to tame inflation. The hike in interest rates would mean that the debt markets instruments will yield higher return compared to equities. This is because the equities carry lower risk during high inflation. Thus, whenever there is news in the market regarding high inflation rates, the investors expect the interest rates hike by government and they re-allocate their portfolio by increasing the weight age in debt instruments. During high inflation the fixed income securities yield comparable returns at par with equities. (Source: Observations and Notes, 2010) Thus, the financial market does react with the news of inflation. But this does not imply that high inflation is always bad for equities since the impact practically differs from one industry to another. While some industries perceive high inflation as favourable others consider inflation as an adverse scenario. Over all it can be said that the news regarding inflation impacts the financial market depending on the aggregate perception of all market participants. How News Regarding GDP Affects Financial Markets In the past it was observed by many analysts that whenever the GDP of the country dropped companies saw their top-line and bottom-line eroding, people lost job, foreign investment dries up, and stock markets perform poorly. Thus, the GDP numbers are regularly factored by the investors. When the market participants get the news that the GDP numbers for the following quarter would be better than the current, they start putting their money in the markets and the financial markets perform well. The reverse situation occurs when the GDP numbers are not expected to do well. This is because GDP impacts on all economic factors in a country. (Source: Moneyworks4me, 2011) The above diagram explains how the increase in Growth rate or GDP leads to rise in stock prices. Higher growth indicates higher employment and disposable income. Higher disposable income will lead to higher consumer spending. If a part of this disposable income is invested in the corporate sector, the corporate will realise higher profits. This will mean that the corporate surplus will be invested in productivity sector leading to future revenue growth. All these activities will lead to higher stock prices since with higher demand the company’s profits will surge leading to increased stock prices. To supply for the increased demand the companies would have to increase the investment in new plant and machinery, offices, factories and manpower. All these have positive impact on the stock price movement and the all over financial markets. Thus, from the above discussion it can be said that the investors expect the news of GDP and their reaction from the news depends on whether the GDP will experience an expansion in future or contraction in future. The GDP numbers help the investors to forecast industry performance as well as economic condition of the country and the stocks. When the news regarding GDP is expected to expand economic activity reaches the market, the stocks and the financial markets seems to perform and vice versa. But the financial market does not only look for the GDP numbers to judge the economic condition of the country, they also look for news related to consumer spending, industrial production, government spending, investment growth, and so on. For instance the long term growth of the economy depends on the investment activities. It includes private investment as well as government spending. The news regarding investment is considered as one of the factors that influence stock market prices because it constitutes about an average of 30% of GDP in country. It is a more common indicator for the emerging economies like Brazil, India, and China. During September 2008 to September 2009, the investment in these countries fell from 12% to average 1.5% of GDP. This was mainly due to news of global slowdown triggered by US’s chance of falling into recession and the Eurozone crisis. How News Regarding Oil Crude Prices Affects Financial Markets The impact of news regarding changes in movement of oil prices are reflected in the financial markets around the world. This is because an investor has advantage when the prices of oil are expected to rise. For instance, when the cost of per barrel crude oil is trading at $ 90 per barrel and the market speculation suggest that the prices are expected to rise in future to $ 115 per barrel, the investor will long oil shares and sell them at future date making a profit of $ 25 per barrel. Again the cost of carry and other freight charges depends on the movement of oil prices. This is the reason as to why an investor closely monitors the news of oil price movements. Increase in crude oil prices increases the cost of transportation as well as other items which reach the ultimate consumer through consumption of oil. Thus, from the above discussion it can be said that the oil price movements influences the financial markets around the world. How News Regarding Unemployment Affects Financial Markets On an average announcement of rising unemployment is considered as bad news during recessions and good news during economic expansions. When the economy is experiencing expansion stock prices generally increases as rise in unemployment indicates fall in interest rates in future. At the same time it will also mean fall future earnings and dividends which are considered as bad news for stocks. The impact of unemployment dominates over cyclical stocks (Gonzalo and Taamouti, 2011, pp.1-3). (Source: Crystal Bull, 2013) The above chart shows the impact of unemployment rate in S&P 500 since 1970 which is often considered as a lagging indicator. Generally recessions lead to unemployment while growth in economy creates more jobs. Most employers start hiring after recessions as the economic outlook looks better. It affects the stock markets adversely since historically whenever recession was set on, it took an average of 18 month for unemployment to recover and stock prices to rise. How News Regarding Taxation Affects Financial Markets (Source: 8020Vision, 2010) The above chart depicts tax rate and pre-tax income for top 1% earners in USA. An individual investor may sell stocks expecting the markets to fall due to higher taxes announcements. But it becomes a buying opportunity for high net-worth individuals. Also earnings of company do not change due to changes in tax rates and hence common stocks are independent of any news regarding taxes. However, if corporate taxes fall it will increase corporate profits and investors would buy more company stocks which will push up stock prices (Zhang, 1997, pp.1-5). How the Financial Markets React to News Regarding Natural Disasters In October 2012, hurricane ‘Sandy’ had forced the stock markets in New York to cease trading. It also had implications in other financial markets which also fell from the reaction. According to the chief investment strategist of S&P, S. Stovall, hurricanes do not have long term impact on the stock markets. However, their impact may last about a week or two. He also stated that the performance of stocks after the news of hurricane reached market was random. For instance, the impact of natural disaster news in the equity markets is greatest. This is because the equity markets are driven more by global natural disasters rather than local natural disasters. On October 29, 2012, the Standard & Poor’s 500 reported 4% to 6% gain. This was less compared to the aftermath of hurricane Katrina. Stovall mentioned that after the news of hurricane Katrina reached the stock markets in August 2005, the impact of it lasted more than a month. One of the worst post hurricane financial market performances was after news hurricane Ike reaching stock markets in 2008. The stocks were already experiencing free fall due to the collapse of US housing prices and sub-prime mortgages. After the news of Ike reached the market, it went down by 9% after one month, and over 30% after three months. The market decline did not stop there as even after six months the market fell by 45% (Popp, 2006, pp.63-72). The news of tsunami, earthquakes and nuclear crisis in Japan had impact on the London stock markets as well as other financial markets around the world. The explosion of the nuclear power plant Fukushima in Japan created turmoil in the financial markets as the investors moved their money from the companies exposed to the nuclear sector or power sector. The biggest rise was experienced by stocks of Aggreko when its spokesperson announced that the company is ready help the people of Japan by supplying temporary power. This news immediately picked up the company’s stock by over 8.1 % to £ 15.25. The shares of FTSE 100 fell by 54 points and losing 1% to 5775, which was the lowest in three months. The shares of companies around the world that are associated with nuclear power sectors fell. When the Swiss government announced they all new nuclear projects would be temporarily suspended, the shares of companies like General Electric and French company EDS experienced a 5% fall in their shares. This was mainly because both the companies have proposed to build around 12 nuclear power stations in UK over the next five years. The London stock exchange listed Amec that operates in big nuclear projects including building new plants to decommissioning experienced a fall in share over 3 % and reached £ 11.15. A number of nuclear fuel explorer also suffered losses. For instance, the Kalahari Minerals which specialises in copper, uranium and gold exploration in Namibia experienced 7.7% fall in share prices leading to wipe-out of over £ 60 million market value of the company. The shares of Berkley Resources, a Spanish uranium explorer fell by 15% after the news and announcements. The stock of solar energy companies and other renewable energy generating companies stocks were experiencing upward movement. The shares of US solar company First Solar rise 7% after the news. Based on the impact of energy generation, the investors were moving their money out of luxury goods sector and since Japan is the worlds third largest market for luxury goods, the Japanese economy was hit the most. The trend was replicated in the other parts of the world (Mechler, 2003, pp.36-45). For instance, when the news of nuclear power plant explosion was telecast globally, the shares of LVMH fell over 3% while Gucci experienced a 2.5% fall. According to the views of MF Global, the luxury goods companies were mostly affected in the short term. While some analyst expected that the insurance sector would do well but only few insurance companies saw pick up across Europe. This was mainly because they were worried about potential claims in the short term by the affected population of Japan. One of the UK’s largest insurer Aviva’s shares fell more than 3% on concerns over financial loses. Impact of Industry output News / How News Regarding Taxation Affects Financial Markets In the year 2008, Priestley and Cooper investigated the relation between future stock prices and economic indicators such as the industry output of US. Their result was published in a paper where they had defined output gap as deviation of log of industrial outputs. The paper concluded with evidences that the industrial output can be used to predict stock returns as monthly, quarterly or annual forecast. This means that when news regarding industrial output numbers is periodical reviewed and published, the investors react to them. Their reaction is reflected in the stock prices and mostly to those stocks under the manufacturing and industrial sector. Generally, if the output numbers are higher, the stock markets react positively and the all over market shows price rise. For instance, the HSBC Purchasing Manager Index is one of the economic indicators which measure the performance of industrial output for developing countries. The data is published on monthly basis and when the values of PMI is above 50.0, it indicates that the industrial output during the period under observation was able to perform above average. During the period starting from 2005 to 2010, the industrial output and stock price movements showed positive correlation. This means that whenever the industrial output moved up, stock prices in that sector moved up and vice versa. Hence, from this discussion it can be said that the stocks prices reacts to the news of industrial output. How Financial Markets React to Global Crisis The impact of Euro zone’s sovereign debt crisis news on the stock market is reflected most in the banking sector. News regarding tighter credit policies, proper disclosures, austerity measures, bailout plans makes the stock market more volatile. The market sentiments improved from the announcement of ECB for long term financing and providing loans at cheap rates worth € 1.3 trillion to banking sectors. The markets do not seem to wait till actual outcomes. Their reaction is almost immediate as seen during Eurozone crisis when many banks’ credits were downgraded, the stock markets across the globe crashed immediately (Massa, Keane, and Kennan, 2012, pp.31-40). Macro-economic factor that rebounded Eurozone and other economies was the news regarding Long term financing operation supported by USA. (Source: Bloomberg, 2013) The above chart shows that Eurozone GDP fell most since 2009 plunging the stock prices all over the world. The treasury auction in Spain is being closely monitored by the banking sectors and the financial markets. The Spanish banks require new funding and it is expected that the long term liquidity infusion by the government would provide much relief for the Spanish banking sectors. The news regarding capital infusion in the Spanish banks is closely observed by the investors. Their reaction to the decisions taken by the government provides sufficient evidence on how the stock markets react to macro-economic news. Thus, from the election of French president to establishment of New Greek government, the stock markets factor in such important macro-economic news. The markets closely watch for such kind of news because it helps to predict the future of related stocks and where a particular sector is heading. For instance, the banking sector in Eurozone requires immediate capital infusion otherwise they will have to file bankruptcy. This means that the investor who is optimistic about the speculation that the government will infuse liquidity, take austerity measures and consider more bailouts will take long position in the banking sector. On the other hand investors who are pessimistic about the views regarding long term liquidity infusion by the government will take short position in banking sector. Now, a speculator or an arbitrageur does not wait for the actual outcome. Their decisions are made prior to the point when information will be publicly available. This is because it is often found that majority investors buy stock when the stock prices are at their all time highs and about to fall in future. This means that any news regarding important macro economic factors impacts the movement of stock prices. In the year 2011, the news regarding Eurozone crisis had major impact on the secondary stock markets around the world. The sovereign downgrades led to the downgrade of banking and corporate credits as well. Consequently these companies experienced a high rise in cost of financing. They found it difficult to make new deals not just in the domestic markets but in the global market as well. According to Michael Dakin, who is an expert of high yielding bond markets, the European bond yield bounced back in 2012 which was supported by the US quantitative easing 3 which promises to keep short term and long term rates low and infuse over $ 1.3 trillion in the economy by 2015. This new was taken very positively by the investors around the world. The moment the news was available, the secondary markets jumped 20% and a positive sentiment prevailed among the investors. However, Dakin also stated that the news regarding Greek election and other issues will also be watched carefully by the markets around the world. Credit crunch was touted as one of the threats to global financial crisis of 2008 that plunged the stock markets all over the world over 30%. Since the announcement of the news regarding credit crunch, the financial markets became volatile. Government Treasury bills yielded negative returns, the risk premium of corporate bonds soared, S&P 500 was affected worst and declined over 30%, and there was lack of confidence prevailing in the markets. While the stocks have steadily declined to their lowest during the credit crisis of 2007, stock sells intensified which lead to collapse of Lehman Brothers in September 2008. The poor performances of stocks were reflected from the stock and bond markets (Brunnermeier, 2009, pp.78-85). (Source: CQG Inc., 2011) The news regarding sovereign debt crisis in the Eurozone is related to the banking sectors. These banks are currently struggling to follow the Basel III capital adequacy requirements and hence any news regarding reforms, measures, and policies is expected to trigger investor reactions in the market. The Eurozone news may drive the investors to either pull out their money from the markets and book profit or they may drive the investor to put their money in the banking sectors. As soon as the news hits the stock markets, the investors start to react and their decision is reflected in the stock price movements. The stock markets show the movements of security prices according to demand and supply. The demand of the market is influenced by the future prospect of the economy, then industry and finally the specific stocks in the relevant sector. If the investors are optimistic about the future of company and industry, they will prefer to hold on to stocks and their demand will push up stock prices and the overall market. If the investor is pessimistic about the future of the company they will prefer to sell stocks which will pull down stock prices and the market as well. These decisions depend on the availability of news based on which the investors take decision regarding future course of action, i.e. to buy, hold, or sell stock. How News Regarding Corporate Scandals Affects Financial Markets In the past few decades many negative headlines about company scandals have threatened their very existence. Some of these companies survived scandals while others floundered. In the year 1982, Johnson & Johnson’s stock plunged 17% after the news scandal regarding one of its pain reliever Tylenol. But as soon as it was proved that the company was not responsible for the allegations, its stocks recovered back to normal in 45 days. After one year the company’s stock returned 30% above lowest point during scandals. This was mainly because the company was able to handle the scandal effectively through regular press releases and transparent investigation. Such tactics helped the company to develop and maintain consumer confidence (Hevesi, 2003, pp.3-5). One of the world’s largest oil exploration and production company, ExxonMobil was involved in a controversy in the year 1989 when one of its tankers hit Alaska’s reef and spilled million gallons of oil. The media reported that reason for such accident included inadequate crew members in ship, poor radar maintenance, poor decision making and human errors. After the incident, ExxonMobil was asked to pay $ 5 billion by the federal court for causing damages which were later reduced to $ 2.5 billion. But the point to note here was that ExxonMobil stocks hardly reacted to the news of spill. Over the period of the time, the investors did not lose confidence from the company and the stock only fell by 4% even after the fine was announced. Some analyst believes that the oil stock price depends on the demand and supply equation and hence news and announcements have minimal impact on these stocks. This is was proved by ExxonMobil that even though the company suffered huge lose and paid a hefty fine, the demand for oil remained unchanged in the market. This ensured the stock prices of ExxonMobil to remain almost unchanged during the oil spill scandal. Drug maker Merck was facing serious issues with one of its largest selling drug Vioxx during the second half of the year 2004. It was alleged that the company’s drug Vioxx increased the chances of heart attacks in patients. It was also reported that the company was aware of such risk but did disclose it to public during clinical test or after launch. Merck was known for its strong R&D and good reputation in market. This scandal surprised the investors so much so that the company’s stocks fell by over 35% from $ 45 to $ 32.87 on the day the news first broke. After investigation it was proved that the company was actually aware of the potential risk for using the drug but tried to cover them. The stocks of Merck continued to fall ad after 40 days from first news announcement till the investigation, the stocks traded at its lowest in a decade of $ 26. After this scandal many news media were of the view that Merck would not be able to survive such negative media hype and law suits. But the company’s stocks reached a new level during the year 2007 when its former CEO was replaced. The company did not give away to law suits but fought them with integrity and at the same time launched new products in the markets. The investors slowly regained confidence in the company and finally it took the company over two years to reach new all time highs. The recent news investigation regarding the manipulation of London Interbank Offer Rates has affected the stocks of many banks including UBS, Barclays and Royal Bank of Scotland. These banks were alleged to manipulated interest rates for profit making. The further investigations are also expected to put banks such as Bank of America, Deutsche Bank and Citigroup under the scanner. Barclays bank was fined $ 450 million to UK and US regulators for manipulation of LIBOR between 2005 and 2009. Thus some companies survived scandals while others failed and some companies failed to exist. Most of these were result of illegal or fraudulent activity (Enron), or undue risk taking (Lehman Brothers). Some common aspects were that large capital companies were able o weather financial storms through external funding and also companies with long history and reputation was able to access new fund sources more easily. The external causes were found impact the company’s stock price movements for short term only while the long term impact was mainly due to internal causes. How News Regarding Merger & Acquisitions Affects Financial Markets Marvel Entertainment, Inc. was acquired by Walt Disney in the year 2009 which valued the deal at $4 billion. Prior to the Merger, the shares of Marvel Entertainment were trading at $48.37, below the merger value. The news of merger increased the valuation of Marvel because the second quarter of 2009 was experiencing a bullish phase. Generally, the M&A activities take place when the market is at bottom since lower stock prices are attractive to potential buyers. Sometimes even after the announcement of merger, the stock price of the target does not reach the expected market valuation which could be due to uncertain lower prices. Again, if after the announcement of merger the deal does not actually take place, then the past data shows that stocks prices of those targets fall significantly (Baker, Pan, and Wurgler, 2010, pp.2-5). Conclusion From the above discussion it can be said that news has direct impact on the financial markets be it positive news or negative news. News for the market participant has the ability to change good day into bad and vice versa. The relationship between news and stock markets can be highly unpredictable since the next headline may turn out to be bust or boon. The effect of news on the financial markets and the results of the research can be summarised in a few key points. Firstly, good news has positive impact on stock prices. Secondly, the market participant reacts more quickly to negative news across the globe. Thirdly, slightest worry among the investors is enough to tumble the stock markets. Fourthly, the effect of news on financial markets depends on the sentiments of market participants. Fifthly, sometimes the news may be bad but the stock markets may not have a bad day after all. And lastly, news regarding inflation, crude oil prices, GDP, unemployment, merger and acquisitions, industrial productions, insider trading, global cues scandals, war, terrorism, natural disasters, new breakthrough in technology, and government policies seems to have significant impact on stock price movements and financial markets. References Baker, M., Pan, X., and Wurgler, J., 2010. The effect of reference point prices on mergers and acquisitions. [Pdf]. Available at: http://www.csom.umn.edu/finance/seminars/documents/Jeffrey-Wurgler-paper.pdf. [Accessed on March 19, 2013]. Brunnermeier, M. K., 2009. Deciphering the Liquidity and Credit Crunch 2007-2008. [Pdf]. Available at: http://www.princeton.edu/~markus/research/papers/liquidity_credit_crunch.pdf. [Accessed on March 18, 2013]. Gonzalo, J. and Taamouti, A., 2011. The Reaction of Stock Market Returns to Anticipated Unemployment. [Pdf]. Available at: http://www.eco.uc3m.es/~jgonzalo/UnemploymentRateFinancialMarket.pdf. 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Available at: http://kansascityfed.org/Publicat/Econrev/EconRevArchive/1982/1q82pear.pdf. [Accessed on March 18, 2013]. Popp, A., 2006. The Effects of Natural Disasters on Long Run Growth. [Pdf]. Available at: http://business.uni.edu/economics/themes/popp.pdf. [Accessed on March 19, 2013]. Zhang, L., 1997. The Impact of Transaction Tax on Stock Markets: Evidence from an Emerging Market. [Pdf]. Available at: http://www.ecu.edu/cs-educ/econ/upload/zhangli.pdf. [Accessed on March 18, 2013]. Appendix Regression Models to Understand How News Affects Financial Markets Read More