Macroeconomic Analysis: Key Economic Fundamentals

Macroeconomic analysis examines factors that affect the economy in its entirety. This process is used to evaluate currencies, bonds, commodities, and stock indices, and helps determine if the economy is expanding or contracting (booming or in a slump).

Key factors analyzed at the macro level include interest rates, inflation, rate of growth, employment, politics, and national sentiment.

1. Interest Rates

The interest rate represents the cost of borrowing money for individuals, companies, or governments. Central banks meet monthly to set these levels, which are closely followed by market traders.

  • Higher Rates: Result in more savings and less spending, leading to a decrease in growth and a slowdown in the economy.
  • Lower Rates: Result in higher borrowing and higher spending, leading to an increase in growth.

Market Impacts of Higher Interest Rates:

  • Currency: Demand for the currency increases (people buy currencies with higher rates).
  • Stocks: Negatively correlated. Higher borrowing costs for firms and consumers negatively affect stock prices.
  • Commodities: Can have a negative effect, as the cost of storing commodities increases.

2. Inflation

Inflation is the general increase in the price of goods and services. High inflation rates generally prompt central banks to increase interest rates as a control measure, which affects market dynamics.

Measuring Inflation:

  • Consumer Price Index (CPI): Measures the changes in the price of a market basket of goods.
  • Producer Price Index (PPI): Measures the change in the production prices of goods and services.

Market Impacts of Increased Inflation:

  • Currency: Tends to increase in value because central banks are expected to raise interest rates.
  • Stocks: Negatively affected. High costs of goods and services reduce firm profitability and lead to decreased stock prices.
  • Commodities: Generally rise in price, as commodities are goods and their value accelerates with inflation.

3. Economic Growth

Growth measures the health of an economy through the increase in goods and services produced. It is the most watched economic indicator because it enables increased living standards and job creation.

Indicators of Economic Growth:

  1. Gross Domestic Product (GDP): Measures the total value of all goods and services produced within a country.
  2. International Trade Balance: Measures the difference between imports and exports.
  3. Retail Sales: Measures growth through consumer expenditure.

Market Impacts of Increased Growth:

  • Currency: Higher output and income increase government revenues, thereby increasing the currency's value.
  • Stocks: Increased consumer demand results in higher profits for businesses and higher stock prices.
  • Commodities: Businesses produce more, increasing demand for raw materials and energy, resulting in higher commodity prices.

4. Employment

The job market is a critical macroeconomic factor. Unemployment occurs when people are actively searching for work but unable to find it. An increase in unemployment signals a slowdown in the economy.

Key Employment Indicators:

  • Unemployment Rate: The percentage of the workforce without jobs but able and willing to work.
  • Non-Farm Payroll (NFP): Measures the number of additional non-farming jobs added monthly.

Market Impacts of High Unemployment:

  • Economic Effect: Consumer spending falls, leading to reduced growth.
  • Currency: Demand drops, resulting in the depreciation of the currency's value.
  • Stocks and Commodities: Lower consumer spending and reduced production levels drive stock and commodity prices down.

5. Political Risk

Political risk is the potential for an investment's return to suffer due to political changes or instability, such as nationalization, higher taxes, or increased regulations.

An increase in political risk leads to declining confidence and increased uncertainty, which has a negative effect on all markets.

  • General Markets: Declining confidence causes a drop in the value of currencies and stocks.
  • Commodities: Majority drop in value, with the exception of gold, which serves as a safe haven asset during uncertainty.

6. Sentiment (Market Psychology)

Sentiment is a psychological measure of how people feel about the economy or an asset class. Optimism leads investors to anticipate future growth.

  • Positive Sentiment is referred to as Bullish.
  • Negative Sentiment is referred to as Bearish.

Measuring Sentiment:

  • Purchasing Manager's Index (PMI) / IFO Report: Measures business manager's sentiment.
  • Consumer Sentiment Index: Measures consumer opinion toward financial health.

Market Impacts of Optimistic Investor Sentiment:

  • Currency: Increased demand for the domestic currency.
  • Stocks: Positively correlated; optimism leads to investment in high-potential stocks, resulting in higher stock returns.
  • Commodities: Drives demand, causing values to appreciate.

Market participants must keep a close eye on these macroeconomic fundamentals as changes directly affect the valuation of all major asset classes, enabling them to make informed trading decisions.

Detailed Summary

Macroeconomic analysis involves evaluating factors that affect the economy as a whole, such as interest rates, inflation, growth, employment, political risk, and market sentiment, to determine if the economy is expanding or contracting. Changes in these key fundamentals directly impact the valuation of major asset classes, including currencies, stocks, and commodities. For instance, higher interest rates generally slow growth, increase currency demand, and negatively affect stocks. High inflation prompts rate increases and negatively impacts stocks, while boosting commodities. Strong economic growth (measured by GDP, trade balance, and retail sales) increases asset values across the board. Conversely, high unemployment signals reduced growth and causes market values to fall. Increased political risk reduces confidence, negatively affecting most assets except for gold, and optimistic sentiment (bullish) drives demand and valuation higher.

Key Takeaways

  • Macroeconomic analysis evaluates the overall economy to assess asset classes (currencies, bonds, commodities, stocks).
  • Key factors analyzed include interest rates, inflation, rate of growth, employment, politics, and national sentiment.
  • Interest Rates: Higher rates encourage savings, slow growth, increase currency demand, and negatively affect stocks and commodities due to higher borrowing/storage costs.
  • Inflation: Measured by CPI and PPI. High inflation typically prompts central banks to raise rates, increases currency value, negatively affects stocks, and accelerates commodity prices.
  • Economic Growth: Measured by GDP, International Trade Balance, and Retail Sales. Increased growth raises standards of living, increases currency value, and boosts stock and commodity prices.
  • Employment: High unemployment (measured by Unemployment Rate and NFP) signals an economic slowdown, reducing consumer spending and causing currencies, stocks, and commodities to depreciate.
  • Political Risk: Instability (e.g., nationalization, higher taxes) causes declining confidence, negatively affecting most markets, though gold acts as a safe haven.
  • Sentiment (Market Psychology): Optimistic (Bullish) sentiment leads to increased demand and appreciation in currencies, stocks, and commodities. Sentiment is measured via the PMI/IFO Report and Consumer Sentiment Index.