Welcome to Macroeconomic Analysis! In this video, you will learn about interest rates, inflation, growth, employment, and politics and sentiment.

Overview

Macroeconomic analysis is used in the evaluation of currencies, bonds, commodities, and stock indices. At the macro level, analysis examines factors that affect the economy in its entirety. This includes interest rates, inflation, rate of growth, employment, politics, and national sentiment. This analysis will tell us if the economy is expanding, contracting, booming, or in a slump.

Interest rates

The interest rate represents the cost of borrowing money – either by individuals, companies, or even governments. If people and companies borrow less, they have less money to invest and to spend, and vice versa. If interest rates go up, this will result in more savings and less spending, eventually leading to a decrease in growth. If interest rates go down, this will result in higher borrowing and higher spending, and in turn lead to an increase in growth. Central banks meet monthly to set interest rate levels and these meetings are closely followed by market traders.

An increase in interest rates will result in more savings and less investments and spending – which will then cause a slowdown in the economy. Higher interest rates mean demand for the currency increases as people sell currencies with lower interest rates in order to buy the ones with higher interest rates. This will cause the value of the currency to increase.

Stocks and interest rates are negatively correlated. Higher rates imply higher costs of borrowing for both consumers and firms – this will have a negative effect on stock prices. If interest rates increase, it means the cost of storing commodities will increase, and this can have a negative effect on commodity prices.

Inflation

Inflation is the increase in the prices of goods and services in the economy. When inflation increases, more money is needed to purchase the same quantity of goods and services, which will eventually result in a decrease in growth. A typical measure of inflation is the consumer price index or CPI which measures the changes in the price of a “market basket" of goods. Another measure of inflation is the producer price index (PPI), which measures the change in the production prices of goods and services. Inflation has a direct effect on the economy – this is because high inflation rates will prompt central banks to increase interest rates.

Central banks use interest rates to control inflation. An increase in inflation will have the same effect as interest rates on markets with the exception of commodities. When inflation increases, central banks tend to increase interest rates – which causes an increase in the value of the currency. Inflation affects the competitiveness of an economy. Inflation increases exports due to higher costs of goods and services and this will have a negative impact on the profitability of firms and their stock price accordingly. Commodities are goods and therefore, their prices usually rise when inflation is accelerating.

Growth

Growth measures the health of an economy through the increase in goods and services produced. It can be monitored through the following indicators: (1) GDP, (2) international trade balance, and (3) retail sales.

The most important way to measure growth is by the gross domestic product (GDP) which measures the value of all goods and services produced within a country. Another indicator of growth is the international trade balance, which measures the difference between imports and exports. Retail sales also measures growth through consumer expenditure, and it is used to assess the direction of an economy.

Economic growth is the most watched economic indicator because it enables increased living standards, improved tax revenues and helps create new jobs. Having other things equal, higher output, and higher income will increase the revenue of the governments and thus, the value of its currency. When it comes to stocks, an increase in growth reflects the increasing demand by consumers, which in turn results in higher profits for businesses and higher stock prices. Now, because businesses are producing more, their demand for commodities like raw materials and energy will increase, resulting in higher commodity prices.

Employment

Another important macroeconomic factor that should be examined, is the job market. One of the most important ingredients of a healthy economy is the availability of well-paid jobs. When a person is actively searching for employment, but is unable to find work, unemployment occurs. Unemployment is measured by the unemployment rate, which is basically the percentage of the people in the work force without jobs but are able and willing to work. Non-farm payroll also measures employment through the number of additional non-farming jobs that are added each month. “An increase in unemployment (or a decrease in non-farm payrolls) signals a slowdown in the economy”.

As unemployment increases, consumer spending falls because jobless workers have less money to spend, and those employed worry for the future and tend to reduce spending. When a high level of unemployment exists, economic growth suffers, and demand drops. This will eventually result in the depreciation in the value of the currency. An increase in unemployment will lead to a lower rate of consumer spending, which hurts businesses and drive stock prices down. The same effect is seen across commodity prices as demand decreases due to lower production levels.

Politics and sentiment

Political risk is the risk that an investment's return could suffer as a result of political changes or instability in a country. There are a variety of decisions governments make that can affect individual businesses, industries, and the economy as a whole. These include nationalization, higher taxes, extra regulations, barriers to trade, and many more. For instance, the surprise decision of the UK to leave the EU (Brexit), and the election of Donald Trump as president of the United States, created more talk about political risk than before.

An increase in political risk has a negative effect on all markets. Declining confidence and increased uncertainty lead to a drop in the value of the currency. When it comes to stocks, this will also affect businesses negatively as stock prices decrease. The majority of the commodities take the same turn and drop in value as political risks rise, with the exception of gold which serves as a safe haven in times of uncertainty.

Sentiment is also a very important factor. It is a psychological measure of how people feel about the economy in general or an asset class in particular. Sentiment can be a very powerful influence on the markets if people see a range of factors as being all positive or negative. Positive sentiment is referred to as bullish, while negative sentiment is referred to as bearish. Both the Purchasing Managers Index (PMI) in the USA, and the Ifo (Institute for Economic Research) report in Europe, measure business managers’ sentiment regarding the economy; while the Consumer Sentiment Index measures the consumer’s opinion and feelings towards the financial health of the economy.

Investors tend to be affected by their own sentiment while making financial decisions and this can lead to various effects in the economy. Optimism will lead investors to anticipate future growth in the economy, and in turn, will increase their demand for the domestic currency. Investor sentiment is positively correlated with the stock returns; optimistic investor sentiment has a positive effect on stock returns as consumers who believe the economy is going to expand will invest in the stocks of the businesses that have high potential for growth. Eventually, this will drive the demand for commodities which in turn may appreciate in value.

Conclusion

The above indicators provide us with a view on the current and future prospects of the economy. Changes in the above fundamentals will directly affect the valuation of currencies, bonds, commodities, and stocks. Therefore, market participants should keep a close eye on these fundamentals and use them to take informed trading decisions.

Recap!

In the next video, we will talk about microeconomic analysis. Thank you for watching!