In this article, Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022) elaborates on the concept of economic indicators.
This read will help you understand in detail the types of economic indicators, their impact on stock prices and their use by investors in the financial markets.
Economic indicators are statistical data related to economic activity. They help to evaluate and forecast the health of the economy at the macro level. These indicators measure the systematic risk of the economy and are widely used by investors for their investment decisions. Economic indicators are generally published on a regular basis in a timely manner by governments, universities, and non-profit organizations. To build economic indicators, these institutions use census and surveys. For example, the U.S Bureau of Labor Statistics publishes a monthly report on the Employment Situation through a survey. This report details about the jobs lost or created every month, compensation costs, unemployment rate, etc.
Economic indicators can be of great use if interpreted accurately. Historically, it has had a strong correlation with the economic growth of a nation. The impact can be clearly seen in the long-term performance of the financial markets and therefore investors keep a close eye on them. They try to evaluate and understand the impact of each of the economic indicators to make informed decisions. The government, economists, corporations, and research organizations are the other beneficiaries of these indicators.
Types of economic indicators
Economic indicators that help understand and forecast the future health of the economy, are termed “leading indicators”. These indicators tend to precede economic events and therefore prove to be critical during times of economic recession. A single leading indicator may not prove to be accurate, but several indicators analyzed in conjunction may help in providing insights into the future of the economy. Economists, investors, and policymakers may use and analyze these indicators according to their interests.
The evolution of the stock market is one of the major leading indicators. Weak earnings forecasts may indicate to investors the weak state of the economy beforehand. The stock market may therefore tend to decline preceding to the decline of the economy as a whole and vice versa. For the United States, other important leading indicators include the following,
- Daily yield curve rates published by the U.S. Department of the Treasury
- Durable Goods Manufactures’ report released monthly by U.S. Census Bureau
- Manufacturing jobs survey by the U.S. Bureau of Labor Statistics
- Building permits data published by United States Census Bureau
Investors may or may not look at the same indicators as economists. For example, investors would be more interested in the data related to jobless claims by the U.S. Department of Labor to gauge the signs of a weakening economy.
Economic indicators that describe the current state of the economy within a particular segment (such as the job market or the market for goods and services), are termed “coincident indicators”. Coincident indicators move simultaneously along the changes in business cycles of the economy. For example, the payroll data published by the U.S. Bureau of Labor Statistics can help analyze the demand for employees. This evaluation would help understand if the economy’s present condition is strong or weak. Therefore, coincident indicators reflect the real-time situation. They are more useful when used with the leading and lagging indicators. For the United States, other important coincident indicators are:
- Industrial production & capacity utilization report by Federal reserve statistical release
- GDP published quarterly and yearly by Bureau of Economic Analysis
- Real Personal income released yearly by Bureau of Economic Analysis
Economic indicators that describe the past state of the economy which confirms a pattern only after a large movement in the underlying variable, are termed “lagging indicators”. These factors tend to trail the shift in the underlying asset and are therefore useful to validate the long-term trends in the economy. Lagging indicators can further be classified under economic, technical, and business indicators as per their use.
The Lagging Index is published by The Conference Board . This economic indicator lags the composite economic performance of the U.S. This indicator is calculated with following seven economic components:
- Average prime rates
- Average duration of unemployment
- Change in the Consumer Price Index for services
- Ratio of manufacturing and trade inventories to sales
- Real dollar volume of outstanding commercial and industrial loans
- Change in labor cost per unit of output in manufacturing
- Ratio of consumer installment credit outstanding to personal income
Important economic indicators
Gross domestic product
GDP refers to the sum of all goods and services produced in a country during a specific period. The motive is to calculate either the total income or spending in a country and compare it with the preceding period. This difference over time (from a quarter to another or from a year to another) allows economists to understand whether the economy has contracted or expanded.
GDP being the key indicator of the economy, has a significant impact on the investors’ sentiment. A positive change in the GDP would mean that the economy is thriving as compared to the previous period. This would further mean lower levels of unemployment, higher spending, and positive earnings outlook for the companies. This would translate into higher stock prices for investors. Therefore, GDP can be termed as an important economic indicator for both economists and investors.
Inflation (CPI & PPI)
Inflation is referred to the rate at which the value of goods and services rise and consequently the value of currency declines. It is one of the most important economic indicators for investors because it measures the real value of an investment being eroded in a certain period. For example, if the inflation rate is 4% and yield from an investment is 3%, then investors would in real terms lose 1% every year. Therefore, it is a vital factor in investment decision-making, as a higher inflation rate would mean that investor should get an even higher return on their investment. The effect of inflation on the costs incurred by the companies is another factor investor should look at. Decline in inflation would mean lower costs for companies resulting in better overall performance.
The most relevant inflation indexes are Consumer Price Index (CPI) and Producer Price Index (PPI)
- The Consumer Price Index (CPI) is defined by the Bureau of Labor Statistics in the U.S. as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”. It is widely used as a close proxy and estimate to inflation. It helps economists, investors and others get an idea about the change in prices in the economy and make informed decisions accordingly.
- The Producer Price Index (PPI) is defined by the Bureau of Labor Statistics in the U.S. as “a measure of the average change over time in the selling prices received by domestic producers for their output”. It differs from the CPI as it calculates the cost from the perspective of the producer instead of the consumer. It is an important tool as inflation can be tracked in the PPI much before any other economic indicators (including the CPI).
Interest rates are vital economic indicators both for economists and investors. In the U.S., the Federal fund rate is the interest rate at which the banks borrow from each other on an overnight basis. It is targeted by the Federal Open Market Committee (FOMC), which is the monetary policy making body in the U.S. The FOMC sets this target rate eight times a year. The announcement of the changes in the Fed rate is religiously followed by investors. This is because rate adjustments are decided by the FOMC after careful consideration of several economic variables ranging from inflation to employment.
Financial markets (both equity and bond markets) generally react heavily as even a minor rise or decline in this rate can significantly impact the borrowing costs of corporations.
Article written by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022).