Economic measures throw up an alphabet soup: GDP, GNP, RPI, CPI, PMI – the list goes on. But the methods of measuring economic development are a complex and not always entirely accurate business.
The larger the organisation, the more complicated the calculations. Small businesses are relatively easy to fathom by simple accounting measures, but reckoning the economic performance of a country is profoundly challenging.
But that is not the job of a trader – he must trust the economists' sums are correct and use the results to inform him of the likely mood of the market.
Economic performance and the markets
In this introductory guide, we'll deal mainly with the economic data that tends to have the largest impact on financial markets.
Investors tend to divide the data into two categories:
- Backward-looking data
- Forward-looking indicators
The first is easy to explain: this is the data that has been measured over the previous weeks or months that can then be calculated into a reasonably accurate final figure.
But with forward-looking data, how do you measure something that is yet to happen? You ask business and economic professionals for predictions based on current conditions.
So let’s look at some of those measures and try to fathom just how useful they really are?
1. Gross domestic product (GDP)
This is the total economic output of a country, the value of all the finished goods and services produced, usually published quarterly. It can be calculated by adding consumer spending, government spending, investment and exports, and subtracting imports.
Market uses: As a sign of the relative economic health of a country, it is useful to investors with more of a long-term outlook to ensure their investments in a particular country are likely to be safe.
Critics: Few traders wait with nervous fingers twitching for this data to arrive. The number (usually expressed as percentage growth) is first presented as a "flash estimate" in the week or so following the end of the calculated quarter.
This will be updated a couple more times over the following weeks, so by the time the final figure is in, it is no surprise to the market.
2. Gross National Product
Although similar to GDP, GNP measures the value of all finished goods and services produced annually by a country’s nationals. It, therefore, includes those goods and services produced by expatriate citizens and domestic companies based overseas, but excludes what immigrants to the country have produced and earned.
Market uses: Market analysts do not tend to use this measure, preferring the GDP number as a measure of domestic economic health.
Critics: The US Bureau of Economic Analysis prefers GDP as its measure of economic output due to “the increasingly global nature of national economies and the interdependence of labour forces, supply chains and sales channels”.
Most countries including the US and UK use a measure called the consumer prices index (CPI). It is calculated using a basket of goods and services, which include transport, food and medicines.
It takes an average of the individual price changes, weighted according to reflect frequency of sales.
Market uses: Inflation is an important guide to the health of an economy, but is more important to investors as an indication of likely interest rate moves.
The higher the inflation, the more likely interest rates will be lifted to counter inflationary effects. Bonds and currencies are particularly sensitive to rates.
Critics: Some believe the retail prices index (RPI), which is rarely used now, to be a truer measure of inflation as it includes rises in mortgages, rent, housing tax – which the CPI excludes.
Differences also in the calculation of the two means that RPI is always higher than CPI – good for government pension calculations.
Every country has its measure of employment, but let's look specifically at that of the US, because it is a data release of global importance.
The US Non-Farm Payrolls report (published on the first Friday of every month) measures the number of jobs created during the previous month – not including seasonal farm workers. It also gives a percentage reading of the number of unemployed and wage growth.
A hierarchy of data exists and this is one of the most highly anticipated. It gives an insight into the labour market of the world's biggest economy and has the ability to move global financial markets.
Market uses: Everything stops, day trading positions closed out, everyone gathered around the newswire ticker. No-one wants to be caught out of position for this data, perhaps the most eagerly and nervously awaited release of the economic calendar.
It really can move every market if the number is big enough, but forex and bond traders are the ones most likely to get caught out if they are positioned badly for the news.
Critics: Revisions to data from past months are frequent and can vividly alter the picture. This leads to some criticism that the data are too backward looking to be entirely useful. But try telling that to the trading floors on the first Friday of each month.
Productivity is a ratio between output and inputs. It measures how efficiently production inputs, such as labour and capital, are being used in an economy to produce a given level of output.
Data on productivity are included in quarterly GDP reports, while companies in certain sectors such as mining and oil production release regular statements on productivity.
Market uses: The OECD produces international league tables. Employers and governments use it as a stick to beat workers. “Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker,” argued Paul Krugman in The Age of Diminishing Expectations (1994).
Critics: Noble Francis, chief economist at the UK’s Construction Products Association dismisses productivity as a crude measure: "Productivity ignores quality. Doing things better, or killing fewer people, do not count towards productivity," he says.
5. Sectoral data
There are many other important data points which are closely followed by certain sectors of the market:
- Trade account data – a measure of a country's exports compared with its imports
- Retail sales data – monthly sales from a country's retailers
- Durable goods data – monthly sales of white goods and other big-priced items (mainly US)
- House price data – useful guide to overall economic health
- Industrial production – a measure of output of the industrial sector
6. Purchasing Managers' Indexes (PMI)
Called PMI in most countries, this measure is known in the US as the ISM Index (Institute for Supply Management) and surveys the purchasing offices of industry across sectors, separating manufacturing and services.
New orders, inventory levels, production, supplier deliveries and employment data are all gathered and collated to produce an index, expressed as a number. Any number of 50 or above indicates growth, while below 50 suggests contraction.
Market uses: This data is often used as a guide by economists to estimate future GDP readings, and so is seen as a measure for likely market confidence in the coming weeks. There is a strong correlation between PMI readings above 50 and bullish stock markets.
Critics: Not all business cycles are the same. Some are seasonal, others are more linked to the overall economy. So, in countries dominated by just a couple of industrial sectors the data may not be that useful.
7. Consumer confidence
Consumer spending drives the economy. This is why inflation and unemployment are such important data, so a measure that gives some insight into levels of optimism of those spending their earnings is useful.
Every major capitalist country produces some form of confidence index and is based on a survey of a number of households that are asked about current and future business conditions, current and future employment conditions and household income.
Market uses: Changes in consumer confidence can encourage manufacturers to alter inventory levels, while markets are given a suggestion of the likely path of consumer spending. As confidence ebbs, the likely first markets to be hit are the consumer-facing sectors of the stock market – retailers, luxury and durable goods etc.
Critics: Since consumers don't necessarily have perfect knowledge of the state of the economy, their future assessments are more likely to be driven by current indications, so this data can lag actual improvements in economic growth.
8. Business/economic confidence
There are a couple of measures in Europe that are closely followed by markets:
- IFO business confidence – surveyed and compiled by IFO, the German economic think tank
- ZEW economic sentiment – surveys business and financial analysts in major economies on how optimistic they are about current and future trading conditions
Do economic measures tell the truth?
Be warned: all the indicators of economic development are merely blunt instruments without interpretation or analysis. And the markets don’t necessarily react in the ways the data suggest they should.
For example, if unemployment is falling and the latest data suggest another large fall in the number of jobless, an investor might reasonably expect gains for stock markets.
Consider, however, the impact of “good” data close to the peak of the economic cycle: if the country’s central bank feels the economy is getting a little “hot”, then further good data might prompt interest rate increases.
If markets feel this point is close, they might react negatively to positive economic news.
It is easier to understand what the data means than it is to interpret how the markets might react.