Welcome to lesson four of our course on how to pick stocks! Lesson one looked at setting investment goals, lesson two looked at how to analyse those stocks with quantitative analysis, lesson three looked at earnings reports and lsson four looked at using qualitative analysis.

In lesson five we will look at macroeconomics and how global market forces can affect stock prices. We will cover:

• What the major global factors that affect stock markets are
• How these factors affect stock prices

By the end of this lesson you should be able to:

• Understand how factors like inflation, GDP and currrency strength affect stock markets
• Use this knowledge to make better informed investment decisions

Lets get started!

 

Basic Macroeconomics for Stock Pickers

What is macroeconomics? Is it different than microeconomics? Does either one or both have big impacts on stock picking?

The difference between these two branches of the field of economics is akin to the difference between the forest – a macroeconomy – and individual trees – a microeconomy. The macroeconomics focuses on the big picture of what is going on around the world while microeconomics focuses on smaller parts of the big picture including individual businesses, consumers, and domestic markets.

Both can have a dramatic impact on a stock picker’s portfolio along with other forms of investment, but it is macroeconomic impacts that leave some investors asking themselves “why here, when the local economy is ok”

In the GFC (great financial crisis) of 2008, Australia’s banking system, unlike the rest of the world, remained strong and we avoided slipping into a recession, again unlike most countries in the world. Yet the ASX plunged anywhere between 54% and 38% during the period, depending on the starting and end point.

Here are some of the most important macroeconomic factors impacting investments:

• Inflation
• Interest Rates
• Monetary Policy
• GDP and economic growth
• Fiscal policy
• Currency strength

 

Inflation, Interest Rates and Monetary Policy

The interconnections among these three issues arguably have the biggest impact on the supply and demand for equity investments which translates into higher or lower stock market prices.

Interest Rates, set by central banks as part of a country’s monetary policy, determine how much it costs to borrow money. They are the tool on which central banks rely to control the price of goods and services – inflation. 

Inflation triggers a reaction within this interconnected cycle, forcing a monetary reaction on interest rates. Imbalances between the demand for the goods and services needed by consumers as well as for those needed by businesses to produce what they sell and the supply of those goods and services falls, unable to meet rising demand. Businesses raise their prices to cover their rising prices which triggers rising prices for consumers.

Inflation erodes economic growth, the life blood of stock markets, dragging down stock prices in reaction to rising inflation. A low cost of borrowing stimulates demand which further aggravate inflation. Eventually, the central bank will step in to raise interest rates (the cost of borrowing) to cool demand and lower inflation.

There are two scenarios that can impact stocks causing a reaction from many investors. 

When inflation is moderate – around 2% — and the prices paid to borrow money (interest rates) are low consumer and corporate demand will grow, driving up stock prices especially for growth stocks.

When interest rates rise to tackle rising inflation, many stock prices typically fall in the face of diminishing demand, forcing investors to look for value stocks, especially those that are less dependent on borrowing to operate.

Generally speaking then, moderate inflation and low interest rates are bullish for stock pickers well high inflation and interest rates are bearish.

 

GDP and Economic Growth

GDP measures the total dollar value of all goods and services produced in a country over a specific period. In Australia GDP is calculated and announced to the markets every quarter. GDP is the gold standard for measuring the overall economic health of a country. Economic growth is measured by rising GDP over time. 

As the best indicator of economic health, a strong GDP suggests strong corporate profits now and the potential for continued profits in the future – economic expansion. Weak GDP indicates soft or diminishing demand for the goods and services that drive corporate profit, pointing to economic contraction. The impact of GDP reporting on stock market investments intensifies over time with quarterly numbers rising or falling. GDP that turns negative rings bearish alarm bells as two successive quarters of negative GDP are the generally accepted indicator of an economic recession.

As valuable as GDP is as an indicator, the perceived expectation of the investing community can produce stock market movement that runs contrary to current GDP readings. The problem is timing. GDP is a lagging indicator – in effect telling investors what just happened. The stock market is considered a forward looking indicator – a measure of what investors expect to happen in the future for economic growth. The end result could be market movements in the opposite direction one would expect from the GDP reading – upward stock movements following a weak GDP and market declines following a strong GDP reading.

 

Fiscal Policy

A country’s monetary policy is determined by its central bank, with the power to determine the cost of borrowing money – interest rates – to ensure an economy with stable employment and inflation.

Fiscal policy is set by a country’s government with the power to shape its economy through taxation and spending policies.

Markets crave an expansionary fiscal policy where the central government invests money into growth projects like major infrastructure projects – think bridge, road, and rail construction. To complement the fiscal spending the government lowers taxes on businesses and consumers increasing disposable income available to be put back into the economy via buying products and services.

Expansionary fiscal policy may boost stocks initially but poses long-term risks. Government, corporate, and consumer spending can promote inflation fueled by rising government, corporate, and consumer debt.

Central governments can step in to control raging bull markets with a contractive fiscal policy – cutting spending and raising taxes to fight inflation and reduce its national debt. Contractive fiscal policy is not good for markets, forcing investors to switch their investing strategies from growth to value stocks and other strategies like short selling where investors essentially bet a targeted stock is going to drop in price.

 

Currency Strength

The strength or weakness of a country’s currency can have an impact on its stock market through how it effects three economic milestones:

• Corporate earnings
• Trade competitiveness
• Inflation

In a global world a country’s currency strength or weakness is determined by the supply and demand for the currency on the global foreign exchange markets – forex.

A strong dollar means lower costs for companies that import finished goods or raw materials from foreign manufacturers or rely on domestic source of raw materials to produce goods at home.

The downside of a strong currency is the impact on the demand for exported goods via the higher prices the foreign buyer pays for domestically produced goods.

A weaker dollar will increase demand for exported goods, available to foreign buyers for less. Companies that rely on imported raw materials will pay more, shrinking their profit margins and creating inflationary pressure should they choose to raise prices for their finished products.

For investors this means looking for those sectors that benefit from strong currencies and those that benefit from weaker currencies, which boils down to companies that rely heavily on imports and those that rely heavily on exports. Investors should focus on sectors that gain from strong currencies—typically import-reliant companies—and those that thrive with weaker currencies, such as export-based businesses.

Big picture macroeconomic issues can impact the direction of market movements. The relationship between interest rates, unemployment, and inflation are arguably the most notable example, but there are others.

A country’s GDP is a statement of current economic health which translates to economic growth with rising GDP over time and economic contraction with falling GDP over time. Two successive quarters of negative GDP indicates recession. Although one would expect market movements to correlate with rising or falling GDP, the market can go against the grain, rejecting the lagging indicator from GDP in favor of expectations the market will move in opposite directions.

Fiscal policy set by a country’s central government can support stock markets with expansionary policies on taxation and spending and dampen market strength with contractive policies of higher taxes and debt reduction.

A country’s currency strength supports or weakens importers and exporters.

 

Key Points

• The main macroeconomic factors are inflation, interest rates and monetary policy, GDP and economic growth, fiscal policy and currency strength
• Inflation, interest rates and monetary policy are arguably have the biggest effect on supply and demand.
• Interest rates and monetary policy are how central banks control inflation
• Moderate inflation (around 2%) and low interest rates are positive for investors
• Fiscal policy is set by a country’s government and can shape it’s economy through taxation and spending
• Markets prefer governments to invest in infrastructure projects, though this can increase inflation
• The strength of a country’s currency has an effect on supply and demand.
• A strong currency means lower prices for companies that import goods, but higher prices for companies that export goods.
• GDP is a sign of economic health. Rising GDP indicates a strong, healthy economy.