A nation’s economy has a significant impact on the lives of its citizens and determines its future trajectory. While an average citizen is not necessarily concerned about the health of the economy at all times, an entrepreneur does not have that luxury, he/she has to feel the pulse of the economy to make crucial decisions related to investments, hiring or expenditures. So an entrepreneur has to keep track of the latest economic indicators and know the meaning and significance of them.
According to the Corporate Finance Institute, an economic indicator is defined as “a metric used to assess, measure, and evaluate the overall state of the health of the macroeconomy.” The indicators are divided into three categories, leading, lagging and coincident.
- Leading indicators predict future changes and are useful for short-term predictions related to economic development.
- Lagging indicators as their name suggests, provide indications of changes in the economy with a lag and are used to confirm previously observed trends.
- Coincident indicators provide current information about changes in the economy as they happen.
Indicator Type: Lagging
Usage: Growth in Real GDP is a positive sign for the economy.
GDP is the market values of all final goods and services produced within the domestic boundaries of a country in a particular year. Final goods are those that are used as end products and resales are not included. It is an indicator of the size and health of the economy. GDP is categorized into nominal and real GDP, the main difference is that real GDP is adjusted for inflation. There are two ways to measure the GDP- income approach and the expenditure approach.
GDP= National Income + Capital Consumption Allowance
- National income is the sum total of wages, corporate and government profits, interest, rent and indirect taxes adjusted for subsidies.
- Capital Consumption Allowance measures the depreciation of physical capital over time due to its usage in the production of goods & services.
GDP = C + I + G + (X — M)
C = Consumption, I = Investment, G = Government spending, X = Exports, M = Imports
- Consumption: Personal Consumption Expenditure includes expenditure on durable goods like cars & washing machines, non-durable goods like food & fuel and services like banking & education.
- Investment: It is divided into two categories – fixed investments and change in private inventory. Fixed investments are composed of business equipment, manufacturing equipment, commercial real estate construction and residential construction. Change in private inventory is a measure of additions to a company’s inventory. An increase in the inventory levels of a company is usually accompanied by increased orders from its customers.
- Government Spending: It refers to the amount of money spent by the government on goods & services like roads, infrastructure, education and defense. It is classified into government final consumption spending and government investments. Government final consumption spending is when the government purchases goods & services for current use to satisfy the needs of society. Government investments are the acquisition of goods & services by the government for future use.
- Net Exports: It is the difference between the total exports and imports of the country. If exports are greater than imports there is a trade surplus while vice versa indicates a trade deficit. A trade surplus is desirable, it is a result of more money entering the country than leaving it. Over time trade deficits can possibly lead to significant debt and as a result lead to a devaluation of the domestic currency.
Stock Market Indices
Indicator type: Leading
Usage: Generally if a country’s major stock market index shows an upward trend, it is good for the economy, but it’s not entirely reliable.
The balance defines stock market indices as “a compilation of stocks constructed in such a manner to replicate a particular market, sector, commodity, or anything else an investor might want to track. Indexes can be broad or narrow.”
A broad-based index has a sufficient number of stocks and can be representative of the entire market whereas a narrow-based index has only a few stocks, generally from a specific industry.
Stock market indices of major economies are observed closely by investors across the globe and they are one of the best signals of the market sentiment. Some of the major indices are the S&P 500-(U.S), DJIA (U.S), FTSE 100 (London), Sensex (India), Nikkei 225 (Japan) and Hang Seng (Hong Kong).
There are different ways in which the stocks are weighted, such as price weighting, equal weighting, market-capitalization weighting, and fundamental weighting.
- Price-weighted index: It is a simple arithmetic average of the prices of the stocks included in the index. The divisor of the index is adjusted during stock splits or addition/deletion of stocks from the index. The Dow Jones Industrial Average is a price-weighted index.
- Equal-weighted index: An equal-weighted index is constructed in such a way that there is an equal amount of money invested in each stock in the index. So each stock has the same weighting in the index. The Financial Times Ordinary Share Index is an example of this.
- Market-capitalization weighted index: The index weights are based on the market capitalization of each stock as a proportion of the market capitalization of all the stocks in the index. The index is usually float-adjusted, float or market float is the value of shares held by controlling stockholders, these stockholders rarely sell their shares, and hence these stocks are not available for trading and are excluded from the calculations. Nasdaq Composite Index is a market cap weighted index.
- Fundamental weighted index: The index weights are based on values such as a firm’s cash flow or earnings. Unlike the other weighting methods, the fundamental weighted index is unaffected by changes in the share prices of the index stocks.
Future expectations of a company are factored in its stock prices. Assuming that a company’s earnings estimates are accurate, the stock market can function as a leading indicator of the direction of the economy. For example, if the stock market is down it could indicate that earnings of most of the companies are expected to decrease and that the economy’s growth rate has slowed down or is headed towards a recession.
But generally, stock markets are not viewed as an accurate leading indicator because creative accounting can be employed to window dress financials and stock prices can be artificially inflated through complex trading strategies.
Indicator Type: Lagging
Source: Unemployment rate
Usage: The lower the unemployment, the better the performance of the economy.
It is one of the most important and closely watched economic indicators. It indicates the well-being of the economy and its labour force. Types of unemployment:
- Demand deficient unemployment: A situation in which the company lays of its employees due to muted demand for its products or services, this type of unemployment happens most often during a recession.
- Frictional unemployment: It is experienced by a worker who was recently fired or quit and is looking for a job in an economy that is not in a recession. This occurs when a worker aims to find a job that is more suitable to his skillset.
- Structural unemployment: This situation occurs when a worker’s skills do not match with the jobs available or if the worker is facing location-based limitations.
- Voluntary unemployment: This variant of unemployment occurs when the worker resigns from a job because it is not financially fulfilling.
Generally, low levels of unemployment are preferable. In the U.S, the Bureau of Labor Statistics releases a monthly estimate of the cumulative number of jobs lost/created in the previous month, and figures relating to the percentage of Americans that are unemployed and actively looking for jobs. The non-farm payrolls represent the total number of workers employed by U.S. businesses, excluding general government employees, workers in private households, employees of non-profit organizations that provide assistance to individuals and farmworkers. It is important to note that the unemployment rate only reflects people who are unemployed and are looking for work. If more companies are hiring, it signals that the companies are performing well and more hiring results in more number of people who have money to spend.
Usage: A moderate amount of inflation is necessary to sustain economic growth.
Inflation is defined as the general rise in prices of goods & services over time. There are two types of indicators under inflation-
Consumer Price Index (CPI)
Indicator Type: Lagging
CPI measures the aggregate price level in an economy. It is an indicator of the purchasing power of a country’s currency and the price level of a basket of goods and services. The basket consists of the most consumed goods and services by residents of all age groups. It tracks the change in the current price of the basket when compared to the previous year and the CPI is calculated on a monthly or a quarterly basis. The prices in a particular year (base year) will have an index value of 100 and this value is used as a basis for comparison to determine the inflation level in the economy. For example, a value of 105 in 2021 when compared to 100 in 2010 (base year) indicates that there’s been a 5% rise in the price of the basket of goods & services when compared to the base year. Core CPI is a variant of CPI which excludes prices of volatile components- energy and food products.
Producer Price Index (PPI)
Indicator Type: Coincident
PPI tracks changes in the cost of production in a lot of goods across different sectors such as mining, manufacturing, agriculture, forestry and fishing. PPI also tracks price changes for the services sector of the economy. Prices from thousands of establishments are tracked and recorded each month and it plays an important role in capturing price movements on a wholesale level before price changes show up in retail.
The PPI published by the Bureau of Labor Statistics (US) includes the measurement of approximately 10,000 individual products and product groups. Each measurement period, product group or type, begins with a base period number of 100. For example, if the production of paper in the month of August has a value of 145, it indicates that it costs the paper manufacturing industry 45% more to produce paper in August when compared to July.
Indicator Type: Lagging
Source: Real Interest Rates
Usage: Lower interest rates boost investment activity and stimulate the economy.
Interest rates are the most important tool used by a country’s central bank to influence the economy. Central banks use interest rates with the aim of controlling inflation. Interest rates are categorized into real interest rates and nominal interest rates. The difference between real and nominal interest rates is the fact that real interest rates are adjusted for inflation while nominal interest rates are not.
Formula: 1 + nominal interest rate = (1 + real interest rate) * (1 + expected inflation rate)
When interest rates rise, individuals and companies avoid taking out loans which discourage new investments and promote saving, the vice versa happens when interest rates fall.
Durable Good Orders
Indicator Type: Leading
Source: U.S Durable Good Orders
Usage: Higher durable goods orders augurs well for the economy.
Durable goods orders are an indicator of manufacturing activity. Durable goods are those that require a significant amount of investments and aren’t replaced for at least a few years. There are two types of durable goods:
- Consumer durable goods: These are purchased by individuals and households, examples include washing machines, furniture etc.
- Business durable goods: These are goods bought by companies. Examples include trucks, machinery and aircraft.
The durable goods orders report is released by the U.S. government every month. The durable goods orders take into account all orders, which includes even the unfilled orders of durable goods and shipments for the preceding month. An increase in these orders is an indication of a healthy economy and a decrease is a sign of a troubled economy. Due to its volatility and its frequent revisions, it is a less reliable indicator, but nevertheless, it can provide useful insights in understanding corporate earnings in industries such as machinery, technology manufacturing, and transportation. Usually, the investors use an average of several months of data rather than using the data of a single month.
Businesses avoid investments in durable goods when they are not in a favourable economic/ financial situation and will continue to utilize their existing machines, they’ll resume their purchase only when they have renewed confidence in the economy.
Income and Wages
Indicator Type: Lagging
Usage: Higher wages/income is accompanied by lower levels of unemployment, which is good for the economy.
Ideally, earnings should increase to keep up with the average cost of living but when incomes decline relative to the average cost of living, it is an indication that employers are either downsizing their workforce, enforcing pay cuts or reducing employee hours. Falling incomes can also indicate an environment where investments are not performing well.
The Yield Curve
Indicator Type: Leading
Source: Yield Curve
Usage: An upward sloping yield curve is ideal while a flat, humped or an inverted yield curve does not bode well for the economy.
It is a graphical representation of the interest rates on treasury securities with different maturity periods, the short-term treasury securities are called treasury bills and the long-term ones are called treasury notes and bonds. The yield is displayed on the vertical axis and the maturity period on the horizontal axis. Shapes of a yield curve:
- Normal yield curve: Yield curves are commonly shaped this way therefore they are referred to as a normal yield curve. The yield curve is upward sloping, with the yield on longer-term maturity securities being more than the short-term ones.
- Inverted yield curve: Inverted yield curve is formed when the shorter-term yields are more than the longer-term yields. It is caused due to a change in the perception of long term investors that interest rates will fall in the future as a result of a decline in the inflation rate. An inverted yield curve is an indicator of an economic downturn.
- Steep yield curve: This curve indicates that long term yields are rising faster than short term yields, it’s a positive sign for the economy as it signals an expansion.
- Flat yield curve: The flat yield curve signals a transition period between a normal yield curve and an inverted one. In this case, maturities across the spectrum have similar yields.
- Humped yield curve: This is a rare occurrence where medium-term yields are higher than long and short-term yields, and it signals a slowing of economic growth.
Indicator Type: Leading
Usage: PMI value above 50 suggests an improvement, while a value below 50 suggests deterioration.
The Purchasing Managers’ Index is based on surveys of businesses in a particular sector. The index consists of various surveys of purchasing managers working in the manufacturing or the services sector. The answers to various questions in the survey are compressed into a single numerical value, the two major surveyors in this field are the Institute of Supply Management (ISM) and IHS Markit. The questions are focused on different elements like employment, factory output, new orders, and stock of purchases and the answers are usually categorized into improvement, no change and deterioration. The PMI provides insights into inventory, pricing, employment and sales.
The PMI is a diffusion index- a type of index which measures change across multiple indicators, it indicates whether the economic condition in the company surveyed has improved or deteriorated. The formula assigns weights to each element and multiplies them by 1 (improvement), 0.5 (no change) and 0 (deteriorated).
PMI = (P1*1) + (P2*0.5) + (P3*0)
P1 = Percentage of answers indicating improvement
P2 = Percentage of answers indicating no change
P3 = Percentage of answers indicating deterioration
An index value above 50 suggests an improvement, while a value below 50 suggests deterioration.
Measuring the status and the general direction of the economy is no easy task and it often baffles even the seasoned experts, nevertheless regularly following major economic indicators can offer useful insights to an entrepreneur and reduces the amount of uncertainty they face.
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