Romesh Vaitilingam

Romesh Vaitilingam

Romesh Vaitilingam is a specialist in translating economic and financial concepts into everyday language. He advises the Centre for Economic Policy Research and the Royal Economic Society, as well as investment managers and government agencies.

Books

The FT Guide to Reading the Financial Pages , FT Prentice Hall, 2001

The Ultimate Book of Investment Quotations , Capstone, 1999

The Ultimate Investor , Capstone, 1999

How the economy influences markets

1. The economy is an important driver of the stock market.

   The central economic force of interest rates - plus the assorted effects of exchange rates, inflation, public spending and taxation - will eventually have a powerful influence on overall valuations, whatever the temporary investment craze.

2. In the short term , it can be hard to discern a clear relationship between the economy and the markets.

   The markets clearly react to economic news - the latest figures on production, sales, consumer & producer prices, unemployment, and so on - but the reaction can often seem perverse, with share prices rising on bad news and falling on good news. This is because the markets anticipate the economic news, and securities prices reflect those expectations before the figures are announced. When they are announced, the reaction has less to do with the numbers per se than to whether they are worse or better than the expectations.

3. Over the longer term, the relationship becomes clearer.

   At base, investors are looking for the likely impact of any economic indicator on the future course of interest rates. This is because interest rates are one of the two key variables that affect investment results. They act on share valuations like gravity: the higher the rate, the greater the downward pull. First, an increase in interest rates makes the return on shares vis-a-vis bonds less attractive, typically pushing down their valuations. Second, it means that future corporate cash flows should be discounted at a higher rate, which, unless expectations are revised, will reduce current share values. And third, the higher cost of borrowing generally has a damaging impact on corporate profitability.

4. National output, inflation and expectations of inflation are the key determinants of movements in interest rates.

   If inflation is rising or expected to rise, it probably means the national monetary authorities - central banks like the Bank of England or the US Federal Reserve Board - will raise rates, with typically negative consequences for the stock market. If output - or at least the rate of growth of output - is falling, rates will probably be brought down.

5. The exchange rate is a further important influence on interest rates and share prices.

   A significant decline in the national currency's value against other leading currencies is equivalent to a reduction in interest rates, potentially raising inflationary pressures through higher import prices. But depreciation is also of considerable benefit to companies selling extensively to overseas markets, making their products more competitive and their export divisions more profitable. The possibility of future depreciation also suggests a potential currency benefit from investing in promising shares in foreign companies.

6. Markets tend to react adversely to falling unemployment, at least when the economy is doing well.

   Shorter dole queues hint at a tighter labour market - and the potential consequences of rising inflation and higher interest rates. Increased demand for goods and services raises the demand for labour to produce them. If there are unemployed and appropriately skilled workers available, they will be employed. But if manpower and skills are in short supply, there will be upward pressure on earnings, raising company wage bills and encouraging nervous central banks to take action on interest rates.

7. Rising oil prices are generally good for oil shares but not for inflation.

   The OECD rule-of-thumb warns that a $10 increase sustained for a year adds half a percentage point to inflation and knocks quarter of a percentage point off growth. A sustained boom in crude oil prices inevitably feeds through to higher prices for heating oil and petrol and could add at least half a percentage point to the rate of inflation. High priced oil also has a direct 'micro' effect on profits since it is a significant input in many industries. Airlines are the most obvious victims as the cost of jet fuel increases , but chemical producers that rely on oil as a raw material also suffer. And even service sector companies make some use of energy, whether for travel or simply running their offices.

8. The government's budgetary policy can have a major impact on the markets.

   Ideally, fiscal policy should support the aim of monetary policy to keep growth at around its trend rate without fuelling inflation. In particular, this means that any tax cuts or spending increases should not boost consumer demand when the economy is doing well. By cutting taxes and/or increasing government spending on health, education, transport, law and order, etc., the government can loosen fiscal policy, hence boosting domestic demand. Conversely, raising taxes and/or reducing spending - a fiscal tightening - depresses demand.

9. Many economic indicators provide valuable information for analysing particular sectors of the economy and companies operating within them.

   Statistics for industrial output, for example, offer precise data on the performance of the various sectors that constitute the production industries. These include manufacturing - durable goods such as cars ; non-durables like clothing and footwear, and food, drink and tobacco ; investment goods such as electrical equipment; and intermediate goods like fuels and materials - plus mining and quarrying, which includes oil and gas extraction; and electricity, gas and water.

10. Trade figures also offer valuable insights into the relative performance of different parts of the economy.

    More broadly, the trade balance - whether the country is importing more than it exports or vice versa - can have a significant impact on the sustainability of growth, the exchange rate and the level of inflation. A large and widening trade deficit is generally bad news both for the economy and the stock market.

romesh@ compuserve .com

'Be sceptical of macro-economic forecasts. Forecasters have a very bad track record in predicting genuine booms and slumps. They sometimes fail to forecast a recession even when it has actually started.'

”Paul Ormerod