Lesson 3- Reading the Economy
Business within context of the economy
When you buy shares, you buy co-ownership of that business. How well that
business performs, determines how well your share price will do. How well the
business performs, is determined by good general and financial management, and
the economic climate in which that management must run the business.
A
good economic climate for business would include: Interest rates are relatively
low, which means companies can obtain “cheap” loans to fund expansion or invest
in machinery or extra stock. Because interest rates are low, consumer spending
is high - meaning profits are easy to make. Inflation that is within the
central bank’s plans is also good: This means the central bank would not have
to curb high inflation by increasing interest rates. By raising interest rates,
the average bond-paying consumer effectively has less money to spend. Therefore
he is more cautious with how he spends his money. Producers and service
providers now have to take care not to overprice their products or services so
that the consumer goes elsewhere. So they limit price increases – thus curbing inflation.
We will explain in this chapter how to understand these factors and what they
mean to the share market.
A
low oil price usually also has an effect on inflation: Rising oil prices causes
high petrol and production prices, in turn causing a rise in products as
production and transport costs goes up. The result is a rise in inflation.
However, a drop in oil prices should be reason for lower transport costs
resulting in getting products to the consumer at a lower cost. This could
contribute to lowering inflation rates.
Oil
prices are however out of the reserve bank’s control. Interest rates are not.
The reserve bank lends money to the other banks, which then correlate their own
lending rate with that if the reserve banks. These
banks add a margin to make their money. However every reserve bank decision to
change their lending rate, reaches the consumer through the other banks.
To
be able to read the economy is a key skill for investing. The stock exchange
performance is strongly linked to the country's economic climate.
There
are several indicators that can help us gauge the economic climate. Lets first list them, then discuss these indicators in more
details.
Indicators
of economic climate:
1. Gross Domestic Product
2. Gross Domestic Expenditure
3. Balance of Payments
4. The Interest Rate & Inflation
5. Other Economic Indicators
6. Related indicators: Demography
1. Gross Domestic Product (GDP) is
the sum total of the price of all services and goods produced within a specific
country. It excludes the value of products and
services of companies that operate outside of the boundaries of this country.
It is measured over a certain period of time – of one year.
GDP
is calculated by adding together a lot of numbers: this takes time and GDP
figures are often released much later that the year of measurement. Other
economic indicators can however be used as indicators of the economy’s health.
We will look at these after our discussion about GDP.
The
numbers used in calculating GDP are contained in this formula:
GDP
= C + I + G + E – I
C
= Consumer spending (= the purchase of comsumer goods and services by
consumers)
I
= Investment (= purchase of production equipment and property necessary to
facilitate production)
G
= Government purchases (= purchase of goods and services by government)
E
= Exports (=Good and services produced locally but sold elsewhere in the world)
I
= Imports (= Purchases of goods and services orignating abroad)
Analysis
of this formula will show the investor changes in the above categories. These
figures are published in publications such as the central- or reserve bank’s
quarterly bulletin and summations might be found in financial magazines. By
analyzing the line items and comparing with previous years, it’s easy to see
the trend of Consumer spend, Investment, or Government spend.
Often
GDP is also broken down into a sector-composition: Main sectors are:
Agriculture,
Forestry, Fishing
Mining and Quarrying
Manufacturing
Electricity, gas and water
Construction
Retail, wholesale, catering, and accomodation
Transport, storage and communication
Finance, Insurance, Fixed Property and business services
Community, social and personal services
Central Government
Other Producers
Again
an analysis of these lines can lead the investor to understand changes in the
composition of GDP and which sectors are hinting slowdown or increase of tempo.
How does GDP affect the share market?
An
increase in GDP from the previous GDP figure, means
that increased economic activity took place. This means more money is going
around in the economy, from which a profit can be made.
In
case where growth for the economy is forecast, it is likely for the stock
market to also grow in value. For example, if the GDP forecast for 2007 is 4%
higher than the actual 2006 GDP figures, the economic climate would support
growth of the stock market.
However,
the stock market is the first to feel an economic slowdown - up to 9 to 12
months ahead of a change in economic cycle. Therefore it’s important to also
keep an eye on other economic indicators discussed later on.
2. Gross Domestic Expenditure (GDE)is the sum total of the payments for local products and
services within a specific country. Effectively it measures the total amount
inhabitants of this country within the country have spent over a year.
How does GDE affect the share market?
What
is interesting about Gross Domestic Expenditure, is that it can be divided into
sub sections, based on the durability of certain items on which money was spent
For
example, you can distinguish between durable goods, such as cars or radio’s,
and semi-durable goods, such as
After
that non-durable goods are listed, such as food. And after that comes services
– that aren’t goods at all.
These
can serve as indicators to the economy: The volumes of durable goods bought are
likely the first to be reduced when the economy is under pressure. For example:
If the economy goes down, car sales (Cars are durable goods) will faster go
down than sales of food (Non durable goods). Therefore, if car sales are going
down, you should be moving your shares to companies that produce non-durable
goods, such as food.
In
our example a reduction in car sales can forecast a downturn in the economy. In
case of a slowdown, you might want to keep shares in a food producing company.
However, if a real economic downturn is about to take place, it might be better
to exit the share market and convert your shares to cash in the bank.
3. The Exchange Rate and Balance of Payments
Countries
export to each other and import to each other. For example,
When
The
Balance of payments tells us in which directions money flowed mostly. If the
balance of payments has a deficit (shortfall), it means that the value of
products imported was higher than that which was exported. Therefore more money
left the country, which will likely cause a smaller supply, which could make
that money more pricey. A prolonged deficit could
cause the currency to strenghten: for example:
Assume
the exchange rate is R6.00 for $1.00. If you calculate how much dollars must be
paid to buy one Rand, you divide the one dollar by the six Rands:
$1.00
divided by R6.25 = $0.16
South
African imports more and more from the
4. The Interest Rate and inflation
Interest
rates are part of government’s monetary policy to manipulate the economy.
Within their ability, government aims at achieving economic conditions favorable
to the country. If inflation is too high (meaning prices on consumer goods are
climbing at a high rate), the central reserve bank can increase interest rates.
Banks, who loan their money which they loan out to businesses and individuals,
also have to raise their interest rates to pay for the higher interest levied
by the reserve bank.
The
consumer now pays a higher monthly amount on interest on his house and car, and
has less money to spend on consumer goods. So, demand for consumer goods
decrease, and the prices come down.
Different
theories exist about the relationship between Interest rates and share
prices. Some theorize that as the
interest rate goes up, the economy is stifled, so the share market reacts with
a slowdown. The opposing theory is that a lower interest rate would cause
investors who have invested in interest-bearing securities to rather move their
money to the stock exchange, because of higher anticipate rewards. This again
would push up share prices.
Understanding the economy. All these
economic indicators are explained so that you may understand the economic
context within which business takes place. In addition to watching out for
these statistics, you can watch out for other economic indicators to identify
trends.
5. Other economic indicators
Because
GDP data is so comprehensive and takes so long to calculate, other indicators
can be used to gauge the economy. These indicators are often listed in
financial magazines with the share prices. Some of the most important ones are:
-
Foreign reserves
-
Motor car sales
-
Money Supply
-
Building plans approved for residential homes
-
Inolvencies
-
New companies registered
Although
these indicators are by-products of actual economic factors, they do have the
ability to signal trends. Changes in these indicators allude to changes in the
underlying economic factors.
Let
us use the example of car sales. Car sales are just a small section of the
expenditure on current durable goods. However, the number of cars sold can be
calculated swiftly, and the number of cars sold was also found to correlate to
the total expenditure on current durable goods. Therefore it is considered as
representative to the bigger durable goods expenditure picture. A slowdown in
car sales could therefore signal that consumers are feeling the effects of
inflation, interest rates or a combination of these and other economic
pressures. As an investor, this could stir you to make a decision about staying
in shares that are dependant on buoyant consumer spending, or rather move to
shares earn you income by exporting to countries where purchases of exported
minerals or capital goods are doing well while the Dollar is relatively week
Similar
to car sales, construction data is an indicator of capacity expansion in the
economy: New buildings and homes are adding room (capacity) for more consumers
or producers that are important role players in the economy.
House
price data alludes to the demand for credit within the economy: Most consumers
finance at least a portion of their house cost. Rising prices tell a story of
consumers spending more money on houses; this spending is likely funded by
credit.
As
shown, these indicators are really the symptoms of principle economic factors.
But interpreted, they can signal changes in economic climate before the actual
economic data gets released to confirm the facts. As an investor be cautious to take cognizance of this data, react where
necessary, and when in doubt confirm your suspicion by looking for factually
published economic data contained within the framework of the above numbered
items.
A
last indicator to watch out for is job data. The markets carefully watch such
data to draw conclusions from it: Fewer jobs predict a slowdown in economy, and
visa versa
6. Related indicators: Demography
Population
forecasts are important to the share market, although few investors take the
trouble to take the real long-term view and invest according to data such as
demographic data.
For
example population forecasts can give you an idea of numbers
of people are likely to appear in certain age groups in the not too
distant future. Currently 15% of the population might be between 12 and 16
years of age, however improved healthcare to a wider population causes
reasonable expectation that this could grow to 25% of the population within 5
years, whereas people within the 16-45 age are likely to have smaller salary
growth due to economic slow down and higher interest rates expected within the
next two years.
Such
statistics, if accurate, would make the clever investor move into stocks that
sell popular brand name teenage clothing and sports gear, and out of stocks
that produce luxury goods for the middle-income class.
Practical Section
I suggest that in your ECONOMICS file, you add sections
such as:
·
GDP and GDE trends
·
Demography data and forecasts
·
Exchange Rate data
·
Inflation data
·
Interest rate data
·
Oil Prices
·
Employment data
Keep a steady eye in the newspapers and summarize articles
regarding any of these topics in your file. Soon you will be able to grasp the
internal workings of the economy, how trends interrelate, and how they affect
the stocks you are watching..
You can also make a weekly diary entry to visit some websites,
such as www.bloomberg.com , which will
give you views into global economies such as the
Often banks publish economic data on their websites as well. Can
you find some?
Use these to build your file, and use your file to come to terms with the economic climate and trends which govern the context of business.
Again, use your newspaper or reference websites to find out:
- What are the GDP forecasts for next year?
- What is the current inflation rate?
- What is government's target inflation rate?
-
Based on the difference between actual and target inflation rate, do you think
it is likely to see an interest rate cut, raise, or stability?
-
Looking at inflation forecasts: How would this impact interest rates, and how
would the suggested increase or decrease in interest rates impact on the
performance of the companies you are watching?
Next,
lets learn what we can read in between the lines of
the company's books in || Lesson 4