The COVID-19 pandemic drove a boom in retail investor participation in the global equity market. Ultra-low central bank policy rates to combat the economic shock, cash handouts by governments as well as spare time at home encouraged neophytes to invest in the market for better returns. Retail investors represented 25% of total trading volume in the US in Q1 2021 compared to 11% in 2011! (Source: BNY Melon)
New and young investors can make better investment decisions by following and understanding the macroeconomic context. As an economist and investment strategist, I produced investment recommendations by taking cues from the economic environment.
As you join the investment band wagon, here are some macroeconomic concepts that can aid you in understanding the economic context and connecting it to finance and investment.
Gross domestic product (GDP) and GDP growth: GDP refers to the sum of the final price of all goods and services produced in a country in a year. Its growth rate determines the economic momentum of a country. High GDP growth lifts the average income of the population, boosts local businesses and attracts foreign investment.
Application in finance: Economists and investment strategists use GDP data to identify growth trends in economies and formulate investment recommendations. For instance, robust consumption growth may indicate scope for good investment opportunities in fast-moving consumer goods (FMCG) companies. Strong trade (exports-imports) data should nudge you to look into major exporting companies and their products. National statistics agencies publish GDP data by industry (agriculture, mining, manufacturing and IT, among others), which is helpful to spot growing industries.
High GDP growth, if unchecked, may over heat the economy and stoke inflation (think Turkey under President Erdogan’s leadership). The central bank will need to raise the policy rate to control prices, leading to higher yields and lower returns for bond investors (inverse relationship between bond price and yield).
Infrastructure projects including toll roads, data centers and renewable energy are financed from the cash flow of the project. Higher GDP growth boosts project cash flow as greater economic activity brings more business to existing infrastructure.
Higher economic growth benefits public equities (companies listed on the stock exchange) by creating a more exuberant and optimistic environment for equity and bond investors. It is easier for listed companies to obtain financing, grow revenue through high consumer demand and invest in ambitious ventures.
Inflation: Financial market experts study two inflation indicators— consumer price and producer price inflation. Consumer price inflation (CPI) is used more broadly and reflects the year over year increase in the price of a bundle of consumption items. Producer price inflation (PPI) refers to the growth in price of raw materials and other inputs used by businesses.
Application in finance: Higher CPI inflation indicates rising consumer prices and falling purchasing power of the local currency (known as currency depreciation). Higher producer prices (current environment is a good example) lead to narrower profit margins for firms if they are unable to pass on input prices to consumers.
CPI inflation affects the stock market through various channels. Some sectors thrive while others get depressed. Please check my article on macroeconomics for equity investing to understand how inflation affects stocks.
High frequency indicators: Financial market experts often cite high frequency data to follow the pulse of the economy. High frequency indicators are published monthly and cover different aspects of the economy such as manufacturing activity, consumer spending and factory production. The most common high frequency indicators published by most advanced and emerging markets include:
Purchasing managers’ index (PMI) manufacturing and PMI services: These indices reflect the monthly activity in manufacturing and services sectors in a country. An index value above 50 indicates that the sector is growing month over month, while a value below 50 shows contracting activity. These indicators are particularly useful for heavy manufacturing countries including Singapore, South Korea and Germany as well as services-driven economies such as the US, Hong Kong and India.
Retail sales: Indicates the consumer spending momentum in a country on a monthly basis. This is an important indicator for economic growth and is used by both equity and bond market investors. Retail sales is a good indicator for countries that derive a high contribution to economic activity from consumption, including US, China, India and Indonesia among others.
Bank lending: Or credit disbursal is an indicator to determine the liquidity in an economy and consumers’ and/ or businesses’ access to bank lending. Higher credit disbursal encourages consumer spending and business investment.
Capital flow: Foreign capital flow into or outside an economy influences stock prices, economic activity and local currency. Foreign capital flow can be studied through variables such as foreign direct investment (FDI) and foreign portfolio investment (FPI). FDI refers to foreign investment into setting up factories and acquisition of local companies. FPI is foreign investment into local stocks and bonds.
During high growth periods, countries are likely to attract foreign portfolio capital into stocks and bonds, which could inflate equity prices. This occured in several emerging markets in 2021 during economic recovery from the pandemic. Foreign capital inflow raises demand for local currency and induces local currency appreciation.
Fiscal policy: Refers to the government’s expenditure on the economy and its implication on government debt and deficit.
Application in finance: Government debt and deficit impact government as well as corporate bond yields. Additionally, these fiscal variables are factored into sovereign credit ratings that affect all debt instruments in the economy. High government debt or fiscal deficit worsen a government’s fiscal profile and lead to higher bond yields as debt investors seek higher interest payments to offset the risk of default.
A weak fiscal profile limits the government’s capacity to boost GDP growth through infrastructure spending. For instance, the Indian government was unable to drastically stimulate the economy over the past few years given its weak fiscal finances.
Monetary policy: Refers to the policy rate set by a country’s central bank. The central bank rate affects the yield on all debt instruments in an economy (loans, bonds).
Application in finance: Monetary policy tightening generally detrimentally impacts the equity market as firms face a challenging environment to service their debt servicing cost. Small cap stocks are disproportionately hit as smaller firms and startups with less robust balance sheet are more vulnerable to higher rates.
Higher policy rate, ceteris paribus, raises the return for lenders in the domestic economy relative to other countries. This brings foreign capital into the domestic economy in search of higher debt returns and leads to currency appreciation.
Readers can follow simple macroeconomic concepts such as GDP growth, inflation, high frequency data and fiscal and monetary policy announcements to gauge the pulse of the economy and use these indicators to understand the financial market.
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