Investor Education Series: Evaluating the market – The International Economy

2015-01-09 13:01

Evaluating the market – The International Economy

South Africa has a very open economy and is therefore affected by global events. Open economy means that imports and exports constitute a large percentage of our GDP. The equity market is particularly sensitive to global events because of the effect on our currency and economy.

Global Economic Growth:

Economic growth in South Africa’s major trading partners has a major influence on our exports. When economic growth increases our exports will also increase and vice versa. The current economic slowdown in the United States and elsewhere can already be felt in certain export sectors.  Furthermore, a global economic slowdown has a very negative influence on commodity prices. South Africa is still a major commodity exporter and is therefore severely affected by commodity prices.  Commodity shares will usually be the first to react to a global economic slowdown.  Declining exports will also affect our trade balance and therefore put pressure on the exchange rate of the Rand.  Pressure on the Rand may lead to an increase in interest rates, which is negative for the stock market.

Should world economic growth expand too fast, inflation fears will surface again. Monetary authorities are quick to respond to the any threat of inflation by increasing interest rates.  Despite the positive effects of high economic growth on company profits, higher interest rates will probably lead to a fall in share prices.

Global inflation:

The fact that global inflation in the industrialised world is much lower than South Africa’s inflation rate, has major implications for our exchange rate.  Because prices rise faster in South Africa, the Randmust devalue to keep our economy competitive.  If the Rand does not devalue, our exports will become too expensive and imports too cheap.  Low global inflation will therefore continue to put pressure on the exchange rate of the Rand as long as our inflation rate is higher.

Global Interest Rates:

Lower global interest rates should have a positive effect on the Rand.  Lower interest rates in the US means that an investor can get a higher return on deposits in South Africa.  Unfortunately, higher returns on the money market is not the only factor influencing our currency.  Investor sentiment is much more important and that is dependent on factors like economic growth, unemployment, crime, rigid labour laws etc.  Lower global interest rates should be positive for our stock market.

Global Stock Markets:

Most of the world’s stock markets are closely related to daily movements on the US stock market (Wall Street).  Sharp declines on US stock markets will always affect our market as well as other stock markets negatively.  The main reason for this is that such a decline usually indicates a lack of investor confidence in paper assets like shares.  The 1987 crash is a good example.  Despite good economic fundamentals in South Africa our stockmarket crashed in tandem with Wall Street because of the total lack of investor confidence in shares.  In 1998 the global meltdown on world stock exchanges resulted in a global flight to US government bonds as the safest investment.  Again our sound economic fundamentals did not save the JSE from a bear market.  Global investor confidence can have a major impact on all stock markets. Unfortunately, increases on Wall Street will not necessarily result in higher share prices here. Our own economic fundamentals and profit expectations will then play a bigger role. A positive sentiment on Wall Street will definitely help our shares provided profit potential is good.

US Economic Indicators:

The US economy constitutes more than 20% of the world economy.  For this reason economic developments in the US have a major influence on other economies. We will briefly explain the major economic indicators and the effect of these indicators on share prices.

Consumer price index (CPI):

Inflation as measured by the consumer price index is one of the most important economic indicators.  The CPI index measures the general price level in theUnited States.  Increases in the CPI index have a major influence on interest rates. The monetary authorities will quickly increase interest rates if they see an increase in the general price level. Any increase in interest rates will normally result in a fall in share prices.  Firstly, higher interest rates increase the costs in a company’s income statement and therefore reduce the profit.  Secondly, higher interest rates provide and alternative to the investment in shares.

The Dow Jones is therefore very sensitive to increases in interest rates. The stock market benefitted from this stable inflation and interest-rate environment.  During the 1980s volatile up and down swings in inflation, interest rates and economic growth contributed to the high risk involved in stock market investment.  Since the 1990s less volatile up and down swings reduced the risk in stock market investment and consequently led to an increase in share prices.

Economic growth (GDP):

Economic growth is measured by gross domestic product (GDP). Company profits and economic growth are closely related.  Positive economic growth rates usually lead to increased company profits.  In a recession, companies find it difficult to increase profits.  It is however fact that the stock market will increase 6 to 12 months before an economic upturn.  That is because analysts can predict an economic upturn before it starts.

GDP is normally released every quarter.  GDP growth in excess of 5% is usually construed negatively by the markets.  Very high growth normally leads to higher inflation and can prompt the authorities to increase interest rates.

Non-Farm Payrolls (NFP):

On the first Friday of every month the US authorities release the so-called non-farm payrolls.  Although this is not a statistic, but only a survey, it has a great influence on the market. Non-farm Payroll’s and is a survey conducted with over 300,000 firms that indicate increased employment or unemployment.  Huge increases in non-farm Payroll’s is indicative of an economy growing to fast. Fears of higher interest rates leads to lower share prices.

Producer price index (PPI):

The PPI indicates the general level of prices on producer level.  It is normally a leading indicator of consumer prices.  Changes in the oil price will normally have a much bigger influence on PPI than CPI.  Because increases in PPI can lead to higher inflation, monetary authorities will adjust interest rates.  The stock market is therefore sensitive to changes in PPI.

Employment cost Index (ECI):

The employment cost index is an extremely important indicator has it shows the effect of higher costs on prices.  The effect of higher wages on the employment cost index will be softened by an increase in productivity. Substantial increases inUSlabour productivity caused the employment cost index to the increase only gradually despite wage increases.  Should productivity increases however, flatten out, wage increases can lead to higher inflation and therefore higher interest rates.

New car sales:

New cars sales is a good indicator of the consumer economy.  Increased car sales is indicative of a growing economy and especially growth in durable consumer products.  Companies operating in the retail and especially durable retail sector will generally experience a positive effect on margins and profits.

Evaluating the economy:

The easiest way to evaluate economic indicators is to ascertain the impact on interest rates. If an indicator puts upward pressure on interest rates, the stock market will in general react negatively. There are two main reasons for this. Firstly the higher interest rates increases borrowing costs for the company and thereby reduces its profits. Secondly, interest-bearing deposits provide a risk free alternative to stock market investments.  Higher interest rates means that deposits are more attractive to investors and many will switch out of the stock market to deposits. Both these factors tend to impact negatively on the stock market.

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