What are economic indicators?
No investment exists in isolation from the overall economy. Economic indicators are data on key economic variables recorded at regular periods of time that are used to predict, identify and confirm fundamental movements in economic activity. Used judiciously, the information conveyed by economic indicators can help investors to predict the likely movements of the market. The key economic indicators are:
- Gross Domestic Product (GDP)
- Interest Rates
- Money Supply
You should avoid making investment decisions based solely on an interpretation of one indicator, even if this interpretation happens to be your own. The evidence suggested by one indicator is unlikely to account fully for everything that is going on in the economy.
Gross domestic product (GDP)
The most significant indicator of the health of the economy is the value of the goods and services it produces. This is known as the gross domestic product, or GDP. The GDP figure is published quarterly.
A stable GDP is generally regarded as good news for investors. Rising GDP during a recession is a sign of economic expansion. However, rising GDP in an already strong economy will trigger inflation fears. Inflation is bad news for investors because it eats away at returns. This explains why share prices often fall on news that GDP has increased.
When you hear talk of the Bank of England (BoE) adjusting interest rates, it means that the BoE is adjusting the rate at which it lends money to banks, known as the discount rate. Usually, other interest rates - such as the rates on your credit card or a variable mortgage - will follow the BoE's adjustments, because they pass on the extra costs of borrowing to the end consumer.
Investors watch changes in interest rates very closely. An increase in interest rates slows down not only consumer spending, but it will also hit the future performance of companies. Higher interest rates make it more expensive for firms to expand their business operations by borrowing money or issuing debt, because they will have to pay a higher interest rate on their loans.
High interest rates have a secondary affect of encouraging investors to switch out of equities and into low-risk cash instruments, thereby further depressing share prices.
The unemployment rate measures the number of people available for work and seeking employment. Labour statistics offer a general sense of the state and direction of the economy as a whole. If unemployment is on the rise or few new jobs are being created, it is a sign that companies themselves are not expanding their businesses and the economy may be slowing down. On the other hand, tight labour markets and large-scale job creation indicate a growing, or even overheated, economy.
The reaction of markets to news about unemployment can often seem paradoxical. If the economy is doing well, investors will fear that a fall in unemployment (which you would think would be good news) will be inflationary (more people in work and spending money). Very low unemployment can also be a sign of labour shortages. On the other hand, a fall in unemployment when the economy is in recession is good news for the markets as it suggests an improvement in the overall state of the economy.
Watch out for announcements on changes in the money supply. Obviously, the amount of money in the economy has a significant impact on economic activity. Excessive growth in the money supply causes inflation (the public has increased purchasing power due to the monetary injection), while sharp cuts in the money supply can cool off an overheating economy, or even cause a recession.
If the economy is doing well, a fall in the money supply will be welcomed by the stock market, because it will probably lead to a fall in the rate of inflation. Conversely, if the money supply increases when the economy is doing well, people will be worried that excess available money will increase inflation.