As an investor it is important to understand how economic indicators can impact financial markets, investing and ultimately the value of your investments.
The key to your success will be looking at these economic indicators, extracting what you need to make the right investment decisions.
Economic Indicators are key statistics that show where the economy is headed by monitoring inflation.
The reason why inflation is of paramount importance is based on the fact that it highly influences the level of interest rates.
Stability within the economy is maintained as long as inflation is kept under control. Rising inflation reflects rising prices caused by demand and exceeding supply.
In other words, the increase in prices of goods and services would erode the purchasing power of the money you make, on the assumption that the money you earn does not increase in line with inflation.
To put it simply, Governments use economic indicators as tools to ensure stability within the economy.
Consequently the individual indicators of inflation like the consumer price index; unemployment and gross domestic product cannot be directly manipulated; therefore to slow down (or speed up) the rate of growth in prices (inflation), interest rates are used.
Interest rates determine the willingness and ability of individuals and businesses to borrow money and make investments. Changes in economic activity, when triggered by changes in interest rates, can fuel an expansion or cause a downturn in the economy.
For companies, higher interest rates often mean lower profits. If interest rates rise, companies have to pay more, to borrow the money they require to fund growth of their company.
Eventually, this translates into higher prices for their goods and, often, lower sales. Especially if customers are buying on credit and have to pay higher interest rates for them to borrow. Potential customers may decide they cannot afford to buy products as the cost of credit is high.
The eventual decline in company sales and earnings is something investors anticipate as soon as rates go up. The result is that stock prices go down before the effects of the increased interest rates are actually felt on the company's bottom line.
Conversely, when interest rates fall, company borrowing costs are lower, so their profits on the same level of sales will be higher.
Therefore, customers who buy on credit are more comfortable buying if they are paying lower rates, so they buy more.
This creates higher sales, which will lead to increased company profits. Eventually higher profits will lead to an increase in stock prices.
More often than not, the above situation creates an environment where investors are typically ready to pay higher prices as soon as the Central Bank intervene to cut interest rates in the anticipation of the cycle of increased profits.
As an investor it is important to remember that the price of your stock will change throughout its lifetime because the price you actually obtain will be determined by current market conditions (supply and demand) and more importantly interest rate fluctuations. This will also determine the capital you will gain or lose.
So when next time you hear about economic indicators, always remember how they will affect the value of your stocks and whether you would need to re-evaluate your positions.