Most Important Economic Indicators
Its good to be back with a brand new post after a brief hiatus. I got caught up in the busy schedule of my new job and was thus unable to spare time for any new posts. I still have a long list of topics in the pipeline, and I’m looking forward to keep posting them regularly on a weekly basis moving forward. It’s just that when you are writing about something that you take very seriously, you also have to assume full responsibility and ownership of the content, and give all the time that is needed to do full justice to the subject matter at hand — rather than dishing out any randomly relevant piece of information found somewhere on the net. Today, let’s look into some of the most important indicators used to monitor an economy.
Economic indicators are quite simply the statistical results of an economic activity published by governmental (or quasi-governmental agencies), central banks, universities and even NGOs. It is indeed a massive undertaking, and it is done on a regular basis to keep track of the economic activity and has many important applications in assessing the state of an economy. It can be used to track business cycles, predict future performance, foresee market volatility and even spot potential opportunities. There are many different economic indicators, but the important ones are necessary to assess the macroeconomics and structural policies and their relative levels of importance varies from one region to another. These indicators are further divided into leading (changes before the economy changes as a whole) and lagging indicators (changes after the economy changes as a whole). In the first part of this article, I shall focus on only the leading indicators.
Leading Indicators: Interest Rates, Stock Indices, Real Estate Market, Bond Yields, Manufacturing Statistics and Retail Sales.
Interest Rates: These are the benchmark interest rates set by the central banks that govern that particular country’s financial system, and they represent the cost at which the subordinate banks can borrow money for their operation to maintain the reserve ratio requirements at the end of each working day. Hence, interest rates are one of the important component of the monetary policy made by central banks to govern the country’s economy. It has a direct impact on the cost of borrowing for both businesses and regular customers. It can be seen as both a leading and a lagging indicator. It is leading since any changes to interest rates will immediately bring about widespread changes in the economy. It is lagging since the central banks adjust them only in response to an economic event. For example, the Federal Reserve (USA’s central bank) recently lowered the federal funds rate (same as interest rates) from 2.25% to 2% in September 2019. And they lowered the rates again to 1.75% the very next month. This was done in order to combat the slowing economy and muted inflation amidst the global economic slowdown. Although the stock market responded positively on both the occasions, the impact proved to have only short term effects and the Federal Reserve was recently forced in March to cut the rates down to 1.25% in response to the Coronavirus pandemic. In contrast, the rates were last increased from 2.25% to 2.5% back in December 2018 in order to curb the inflation after a decade of economic growth. Interest rates directly or indirectly influences every length and breadth of the economy, and is thus one of the most important economic indicators followed by analysts all across the world.
Stock Indices: Every country has its own stock market and is represented by at least one stock exchange that serves as an intermediary facilitating the trade between buyers and sellers of financial securities (aka shares of a company). These places are well known for their frantic activities of traders clad in luminous vests making the bid out loud and throwing in coloured slips of paper in a desperate effort to close the bid (in the old days at least, because now the action is mostly on electronic channels). These exchanges (and also other agencies) also produce what is known as a composite index of selected stocks (from as low as 50 to as high as 500). The criteria of selection varies, but the ones that make it are usually some of the top performing stocks in the market. It is basically a sum of all the aggregate gains or losses of all the selected stocks and is a pretty good indicator of the trading activity at any given moment of the market hours. Some notable examples are the DOW Jones Industrial Average which is composed of 30 stocks of large companies listed in various exchanges of the USA, NASDAQ (USA), S&P 500 (USA), FTSE 100 (UK), NIKKEI 225 (Japan), Hang Seng (Hong Kong) etc. The rise or fall of these indices invariably correlate with the economic future of the associated nation. A small word of caution though, the stock exchanges are also a notoriously speculative marketplace and the investor/trader sentiment may not accurately reflect the underlying reality — particularly in periods of market bubbles. So, it is also important to keep a good grasp of market fundamentals as a reliable measure of stock performance.
Real Estate Market: A growing economy is the one that flourishes (mainly) on land, and expands both horizontally and vertically in space. Thus, the real estate market is one of the most accurate and reliable indicator of the health of an economy. A surge in the prices of commercial or residential properties, and the skylines rising high above the sun are all signs of a period of economic growth. When the prices decline, it signals that the number of properties for sale is in excess compared to the number of buyers. That can happen for two main reasons: one, the supply exceeds the demand (and prices just can’t be inflated anymore) and two, the people just cannot afford to buy (also because of high interest rates). There can be other odd reasons, such as the core businesses going bankrupt (like in the Detroit area), water or power shortages and even military conflicts. In any case, even a slight hint of deterioration in the real estate market often does not bode well for the economy as a whole. Case in point, the 2008 subprime mortgage crisis — a housing bubble that almost singe handedly took the whole world down with it. Not just that, a steep rise in the US housing supply was followed by a recession 4 out of 4 times in the last 50 years (as seen in the figure below).
Thus, it makes sense to keep one’s pulse on some of the metrics of the real-estate markets such as the average house prices, housing supply, commercial rates, mortgage rates, mortgage default rates etc.
Bond Yields: Bond Markets are the primary fund-raising avenues for governments and they offer returns in the form of annual interests. These bonds are initially acquired by primary dealers (financial institutions and central banks themselves) in a government auction, and are traded on the open market with any legal participants. They go by different names in different countries, and are often classified into short-term, medium-term and long-term bonds. Bond yield is simply the ratio of interest paid on its original principal to its current price. Just like other financial securities such as equity, bonds are traded on the bond market and its prices are subject to fluctuations based on economic circumstances, but the interest earned by the bond remained the same — unless its one of those index linked bonds with variable interest rates. The yield is a ratio of the interest (also known as coupon) to bond price, and it varies from time to time as the price increases or decreases. These bonds are primarily classified based on their different maturity periods — which can vary from just a few weeks to as many as 30 years. To put it shortly, there are long term bonds and short term bonds. The yield curve for any given government bond is a graph of yields of bonds with different maturity periods with respect to their time of maturity. Normally, one should expect to see lower yields on short term bonds and higher yields on long term bonds, as long term bonds with higher prices indicate a good investor confidence in the economy. A flat yield curve is also considered as a sign of a balanced (if not good) economy. An inverted yield curve is rather an indication of inflation risk that tends to drive the prices of long term bonds down. It is an indicator of a credit crunch and the resulting slowdown in both consumption and output.
Industrial Production
Industrial activity is a key component that determines the health of an economy since it directly affects the GDP and employment rates. Common sense dictates that changes in industrial production levels will have corresponding effects on economic outlook, and there are some relevant statistics that provide an accurate reading of industrial activity. Industrial production is a key economic indicator published by OECD and it represents a change in the volume levels of output across major industrial sectors like mining, manufacturing and construction. Another indicator known as the Purchasing Managers Index is based on periodical survey of managers working in the primary industry and represents a change in the manufacturing or service output levels. A PMI value above 50 shows an increase in output whereas a value below 50 shows a decrease. The farther away the value from 50, the greater the change in the output levels. These indicators are reliable references to foresee changes in future GDP and employment rates, all of which can have direct impact on the perception of direction of economy.
Retail Sales
Retail outlets are the marketplaces where routine economic interactions take place, goods or services are sold and values are realised. The indicators that show changes in retail sales activity are thus one of the primary ways of assessing the state of the economy in advance. The retail sales comprise of a majority of fast moving consumer goods and services such as food, apparels, appliances, gasoline and automobile. There are several other parts of the economy that are closely linked to these industries. Moreover, these figures also indicate the level of consumer spending in an economy. They tend to be seasonal and go higher during the final quarter which accounts for the surge in shopping activity due to holiday and festival seasons. A negative change in consumer spending is a clear indicator of a decline in purchasing power, often due to inflation and high interest rates. Also, reading the inventory data presents conflicting interpretations when read in conjunction with the retail sales data. Thus, these reports can be a very useful tool in gauging the near-term economic outlook.
These five leading indicators should be closely followed by anyone who is interested in forecasting economic outlook for any reason. We shall also discuss the lagging indicators in the next post, and find out how they are important to confirm any early indication provided by the leading indicators. Until then, stay home… stay safe… and happy Easter!
