6.1. Economic terminology
As far as terminology goes, we will attempt to convey an understanding of the following terms: 1) unemployment, 2) interest rates, 3) inflation, 4) money supply, 5) trade balances, 6) GDP growth, 7) investment, 8) consumption, 9) national budget deficit/surplus and 10) consumer confidence.
Unemployment measures the percentage of people who are unemployed. An unemployed person is someone who is not currently employed but is actively looking for a job. While this seems straightforward, the categorization of what counts as being employed or unemployed is not without some controversy.
An interest rate is the amount paid or charged for the use of money over a given time period. In the US economy, the interest rate which is most watched as an influence over the entire economy is the fed funds rate. The fed funds rate is the rate at which institutions can lend reserves (kept at the federal reserve) overnight to other institutions. The federal reserve will target a level for the fed funds rate and this is the primary method in which the federal reserve bank tries to manage economic activity. This is why each federal reserve meeting which involves setting the fed funds rate is watched so closely. Other rates which are watched closely are rates on government bonds which generally are for a longer time period – up to 30 years. The relationship between different rates for money loaned for different amounts of time is called the yield curve and is sometimes looked at as having an influence on the overall health of the economy.
A continuing rise in the level of consumer prices. Inflation is also sometimes defined as a decrease in the purchasing power of money due to an excess of currency and credit. However, we believe that in modern usage, the first definition is more appropriate.
The amount of money in circulation. This amount can be defined in different ways. In the US, the terms M1, M2 and M3 are used to denote different definitions of the money supply with M1 being a more narrow definition and M3 being more broad, that is including more types of “money”. Currency in circulation, savings accounts, travelers’ checks, deposits, checking accounts and certain types of loans can be encompassed in the definition of money. Because deposits often arise out of loans and vice versa, credit expansion will tend to increase the broader measures of money supply.
The trade balance of a country is equal to its total exports less its total imports. If exports exceed imports, the number will be positive and the country will have a trade surplus. If the country’s imports exceed its exports, the trade balance will be negative and the country will be said to have a trade deficit.
GDP stands for Gross Domestic Product and is the market value of all the goods and services produced within a given country or region during a set period of time which is usually either a quarter or a full year. GDP growth is the growth in GDP from one time period in comparison to another time period. Annual GDP growth is a good rough measure of an economy’s health.
Expenditures on durable assets and additional inventories that enhances the ability to provide increased income and/or output in the future.
Household spending on goods and services.
NATIONAL BUDGET DEFICIT/SURPLUS
Each year, all of the government’s spending for that year is called its national budget. If this spending exceeds all of the government’s revenues (mainly taxes) for that year, the government will be running a national budget deficit. In contrast, if revenues exceed spending, the government will have a surplus. A national budget deficit will result in the government issuing more debt to finance the gap between its spending and revenues.
Consumer confidence is a measure of the optimism of consumers regarding the state of the economy. The most commonly cited and used measures of consumer confidence are indices which are based on household surveys which measure consumer feelings and intentions. The two most well-known indices are the Consumer Confidence index compiled by The Conference Board and the Consumer Sentiment Index compiled by the University of Michigan.
6.2. Economic relationships
As far as economic relationships go, we will try to explain the following links: 1) unemployment and inflation, 2) inflation and interest rates, 3) inflation and money supply, 5) investment and savings, 8) government debt and national deficit/surplus, 9) consumption, investment and GDP growth, and 10) factors which influence the balance of trade.
UNEMPLOYMENT AND INFLATION
In 1958, the economist A.W. Philips published a paper which showed an inverse relationship between unemployment and inflation. This observed relationship was called the Philips Curve. Since that time, policy makers and other economists have kept in mind the possibility that low levels of unemployment would result in high inflation. Since policy makers would want both low inflation and low unemployment, the Philips Curve results in policy makers needing to follow a balancing act between the two desirable outcomes. This is one reason why unemployment numbers are watched closely. The Philips Curve is not accepted by all economists and there is also discussion as to whether the inverse relationship described by the Philips Curve is applicable in the long run or only in the short run.
INFLATION AND INTEREST RATES
The general level of interest rates tends to be related to the creation of credit in an economy. It is likely that when interest rates are low, there will be more credit creation in the economy as borrowers should be more willing to borrow money when they don’t have to pay as much in interest. When borrowers borrow more money, demand for goods, services and fixed investments will generally rise as more money is available to be spent. When demand for something rises, it is also likely that its price will also rise. The result is then inflation. So, low interest rates = more money borrowed = more demand = higher prices. The inverse chain of events is also assumed to be true so that is why the Federal Reserve tries to control inflation through interest rates. If it fears that inflation is rising too high, it will try to influence interest rates to rise so that demand falls and prices stop rising too quickly.
INFLATION AND MONEY SUPPLY
Many classical economists will say that the definition of inflation is a rise in prices due to an increase in the money supply. Therefore, there is a direct correlation between inflation and money supply and money supply changes are the only factors which influence inflation. In this view, the more money that is created, the higher the inflation rate. The relationship between money supply and inflation rate is also directly related to the relationship between interest rates and inflation since low interest rates usually result in an increase in the money supply as credit expands.
INVESTMENT AND SAVING
Generally, the higher the saving rate of a country, the higher the investment. The equation which defines the relationship between saving and investment for a country is: Investment = Saving + (Taxes – Government Spending) – Net Exports. Saving is defined as the aggregate sum of all consumers’ disposable income less their personal consumption spending. The grouped items taxes less government spending marks total government saving – that is, government income less its spending. Net exports are exports less imports. If exports exceed imports, then foreigners are essentially borrowing money from a country to finance their purchases from that country. This money which is lent to foreigners will reduce funds available for investment at home. In reverse, a country could import more than it exports, thus indirectly borrowing money from abroad that finances investment at home. Investment is important for growth in a country. Without new investments, a country’s future output cannot increase and its growth will be limited. The sources of investment funds also have an impact on the long-term state of a country’s economy. We will touch on more of these aspects below.
GOVERNMENT DEBT AND NATIONAL DEFICIT/SURPLUS
The national surplus for each year is equal to the amount of taxes the government collects less the government’s spending. If government spending exceeds taxes collected, then the government is running a national deficit. The national surplus/deficit is also called the federal surplus/deficit or government budget surplus/deficit. In the previous section on investment and saving, the government surplus/deficit can be shown to affect investment in that the higher the national deficit, the less money there is available for investment. This is not necessarily negative if the total amount of money available is still adequate for investment. In the case of the United States, for instance, a large part of the government deficit is offset by net imports (or a trade deficit) with foreigners lending the U.S. government money. In this case, the foreign loans can be used to boost the investment which would have been reduced otherwise by deficit spending. Each year’s deficit adds to the cumulative deficit, the total of which would be the outstanding government debt. If government debt becomes very large as a proportion of an economy’s size, investors in the government debt may begin to fear that the government may simply print money (as most money today does not need to be backed by any other asset, it is fiat money) to reduce its debt. Such a solution to reduce debt would debase the value of that government’s money, resulting in high inflation and also high interest rates as lenders would demand higher returns to account for the debasement of the money. Such fears might also lead to the government’s money being worth less in relation to money from other countries.
CONSUMPTION, INVESTMENT AND GDP GROWTH
GDP stands for gross domestic product and is a measure of a country’s total economic output. The equation which shows the components of GDP is as follows: GDP = Consumption + Investment + Government Spending + Net Exports. Therefore, the higher the consumption and the higher the rate of investment the higher the GDP. GDP growth is therefore influenced by consumption growth and investment growth. This is why commentators will often focus on consumer spending reports and also reports of companies’ investment spending.
FACTORS WHICH INFLUENCE THE BALANCE OF TRADE
The balance of trade is the same thing as net exports which is equal to total exports less total imports. As shown in a previous section, the balance of trade can affect funds available for investment in a country. If exports exceed imports, this is known as a trade surplus and if the opposite is true, it is known as a trade deficit. Factors which affect the balance of trade include: prices of goods at home and abroad, trade agreements and barriers, currency exchange rates, taxes and tariffs, consumer preferences and sentiments and the economic cycle at home and abroad. There are different views as to whether a balance of trade deficit is negative, positive or neutral for a country.
6.3. The economy and investments
Regarding how the real economy impacts investments, we will try to show general principles: 1) how interest rates affect bond and stock prices, 2) how currencies are impacted by interest rates, inflation, budget deficits and trade balances and 3) GDP growth and stock prices.
INTEREST RATES AND STOCK AND BOND PRICES
Changes in interest rates have a very direct impact on bond prices. The relationship between bond prices and interest rates is an inverse relationship. That is, when interest rates go up, bond prices go down and vice versa. In contrast, changes in interest rates have only an indirect effect on stock prices and the relationship is not as clear although the general tendency is also towards an inverse relationship.
The reason for bond prices to move inversely with interest rates is simply a matter of mathematics. A conventional bond pays interest at fixed intervals and returns the principal (par value) of the bond at its maturity date. Let us take a newly issued bond which has a par value of US$1,000 and pays interest annually at US$50, or a 5% interest rate. Let’s then assume that interest rates move upwards by 2%. Assuming this move upwards is seen equally across the yield curve, then a purchaser of our bond should expect to see interest of 7%, otherwise he would buy newly issued bonds which paid interest at the prevailing market interest rate. As a result, the price of our bond would drop below US$1,000. It would drop to a level at which the difference between the principal to be paid at maturity and the current bond price would add the equivalent of an extra 2% yield per year. Let’s say there is one year left to maturity on our bond at the time interest rates move up. Then, the bond price would be expected to drop to US$981.31. At the bond’s maturity, the bond holder would receive US$1,000 for the bond’s par value and US$50 in interest. The total “interest” received would be equal to US$1,050 less the US$981.31 purchase price, or US$68.69. This amount represents 7% of US$981.31. This kind of calculation can be applied to bonds with different maturity dates and bonds trading away from par value as well as zero-coupon bonds. The longer the maturity, the greater bond prices will move compared to bonds of shorter duration for a given change in interest rates. The example above showed that when interest rates move up, bond prices move down. Similarly, when interest rates go down, bond prices will move up.
Regarding interest rates and the stock market, the relationship is more complex. In many cases, the likely linkage may also depend on the yield curve (that is the level of interest rates at different maturity rates). One way in which interest rates affect stock prices is through changes in the relative attractiveness between stocks and bonds. When interest rates go up, bonds become more attractive relative to stocks. As a result, stock prices may fall as buyers shift funds to bonds until stock prices are at levels which investors believe adequately compensate them for the increased risk in stocks relative to bonds. The reverse is true for a fall in interest rates.
A second way in which interest rates affect stock prices is the impact that changes in interest rates have on interest expense for corporations. Lower interest rates will result in lower interest expenses, especially for those companies with large debts, allowing the companies to generate more cash. On the whole, this would tend also to result in higher stock prices.
Finally, lower interest rates may also result in a rise in optimism for the prospects of an economy as a whole as the lower borrowing costs may spur an increase in both investment and demand. This increase in investment and/or demand would likely result in a higher growth rate for the economy as a whole.
Changes in interest rates may also come in the form of a change in the shape of the yield curve (the pattern of interest rates according to the length of time that money is borrowed for). Changes in the shape of the yield curve may, in turn, affect stock prices. The actual impact will depend on the specific company and industry in question. For instance, a banking concern generally lends money out for long periods but takes demand deposits which earn a short-term interest rate. Banks, therefore, can be quite sensitive in the gap between long-term and short-term interest rates. When commentators talk about an interest rate rise, they are often referring to Federal Reserve decisions to target higher or lower Fed Funds rates – which are short-term rates which banks earn by lending reserves to each other. It is assumed that changes in Fed Funds rates will affect other interest rates along the yield curve. But sometimes this is not the case. If, for instance, Fed Funds rates go up, which would likely result in demand deposit rates going up, but long-term rates stay flat, Bank earnings may suffer as their cost of funds rise but their revenues do not.
CURRENCIES AND INTEREST RATES, INFLATION, BUDGET DEFICITS AND TRADE BALANCES
The drivers of changes in currency exchange rates is a complex topic. We can describe some of the assumed linkages between currency exchange rates and interest rates, inflation, budget deficits and trade balances. However, this does not mean that you will necessarily be able to project exchange rate changes with any accuracy given the complexity of the topic.
Generally, it is assumed that higher interest rates for a given currency will result in a stronger currency. This seems self-evident, to some extent, as if your return from deposits in a given currency goes up, that currency becomes more attractive. This relationship probably holds much better if the change in interest rates is not reflective of some other factos.
For instance, a raise in interest rates may signal that a country is concerned about inflation. If inflation is likely to be very high in the future, this is generally negative for a currency’s value over time, as inflation erodes the purchasing power of a given currency. Therefore, even though a country is raising interest rates, if it is perceived that that country may have an inflation problem and it looks like the interest rate changes may not be able to contain inflation, a country’s currency may weaken as the fear of inflation overwhelms the higher return from higher interest rates.
Large budget deficits in a given country are generally assumed to be negative for a country’s currency exchange rates. If a country’s government is consistently spending more than it collects in taxes, the deficit is likely financed by government debt. However, if this debt grows to such a large size that the government’s ability to pay it back through future tax revenue comes into question, holders of that country’s currency may lose faith in the value of that country’s currency. This is because those currency holders may fear that the government in question may simply print new money to retire its debt, debasing the value of its currency in the process as the amount of money in circulation grows. However, if the confidence in a government’s ability to manage its finances is not eroded, growing budget deficits may have no impact on a currency’s value. If other factors overwhelm the negative impact of large budget deficits, the currency may even grow in value.
Finally, the relationship between currency value and trade deficits is generally seen in reverse terms from the relationships we have talked about so far. In other words, trade deficits are seen to be the result of a currency that is either under-valued or over-valued. If a currency is very strong, it will make imported goods cheaper and raise the prices of its exports. In this case, a trade deficit is more likely to develop. With a weak, currency, the converse is true and a trade surplus or smaller trade deficit is more likely to develop.
GDP GROWTH AND STOCK PRICES
In the long-run, we would expect average stock prices across a fairly broad index to rise and fall roughly in-line with GDP growth. GDP, or gross domestic product, is analogous to the revenue line for a corporation, but applied to an entire country. From GDP, we get a corporate profits margin. While the stock market generally only reflect conditions at the larger companies in a country, excluding many small and even medium sized businesses, the breadth of company representation in the stock market generally reflects the breadth of a country’s economy as a whole. Therefore, GDP growth should be closely linked to the overall revenue growth of the companies that make up a country’s stock market.
Over time, we would expect corporate profit margins to fluctuate around a certain base level, but be relatively stable over long-periods of time. If margins were constantly growing or constantly shrinking, eventually, corporate profits would be equal to all of GDP or they would be non-existent. Either outcome is not likely.
Similarly, the ratio of stock market capitalization to corporate profits is also likely to be stable over time, although it may see large fluctuations (not taking into account changes in the proportion of a country’s companies that are listed, which may not change much in a very developed country).
Having made the linkage from stock capitalization to corporate profits and then a linkage from corporate profits to GDP, we see that stock capitalization and GDP are themselves linked. When GDP changes, this is likely to impact corporate profits, which will then impact stock capitalization. Assuming in the long run, these relationships are relatively stable, then GDP changes should translate roughly into similar changes in stock market capitalization. If a country is not growing, it is probably not going to see its stock market as a whole do very well.