How Does the Economy Drive Market Trends?
Market prices, whether stocks, commodities, or currencies, are based on supply and demand, and are driven by expectations of future prices. Traders going long hope to profit from prices climbing, while traders going short hope to benefit from prices falling in the future. Economic trends play a major role in shaping expectations which then tend to be reflected in market price trends.
Commodities in many ways are the market most closely tied to economic conditions. During prosperous times demand for goods and services increases, increasing demand not only for physical goods but also for energy as people drive more for work, transport more goods, travel and also consume more electric power. When economic activity decreases on the other hand, as in a recession, demand for resources tends to decline.
The commodity that is generally regarded as most sensitive to economic conditions is copper because it has so many applications. Crude oil also tends to rise and fall with the economy, but also carries within it a premium for the risk of supply disruptions that that rise and fall depending on political tensions in producing regions such as the Middle East and Africa. Longer-term economic trends have some impact on agricultural pricing as diets change as economies develop. Shorter-term trading in grains, however, tends to be impacted more by weather conditions.
Interest in stocks also rises and falls with the economy. Stock prices are driven by expectations of future earnings and dividends, and because of this broad market indices tend to reflect expectations for the economy and business conditions six to nine months in the future. Stocks can also be grouped into industries that respond differently to changing economic conditions.
1) Interest Sensitive – Financials, Utilities, Telecommunications
Interest costs are a major component of these industries? expenses. Because of this they tend to outperform the broad market when interest rates decline and tend to underperform when rates rise. As central banks use interest rates to manage the economy the performance of these groups tends to lead the economic cycle.
Defensives (Consumer Staples and Health Care)
These are products and services that people use every day regardless of economic conditions. Because of this, they tend to grow at a slower pace during expansions but fall off less during recessions. These sectors tend to outperform during times of economic stress and financial turmoil and underperform in the good times.
3) Economic Sensitive (Industrials and Consumer Discretionary, includes Transportation, Communications and Merchandising)
These areas tend to see their fortune rise and fall along with the broad economy and their trends tend to move in tandem with economic expectations.
4) Capital Spending Sensitive / Late Stage (Technology, Energy, Materials)
Growth for companies in these sectors tends to be impacted by larger scale projects that can take several months or years to complete. In recessions, companies tend to hold off on approving new capital spending until signs of an economic turnaround are more visible. Following peaks, companies tend to complete projects they have committed to before cutting their budgets. Because of this, these groups tend to lag a bit behind the economic cycle.
The peak of the last cycle provides a good example of this, as Financials in the US topped out in March of 2007, the S&P 500 peaked in October 2007 and the Energy sector didn?t peak until the summer of 2008.
The structure of each country?s economy and the weighting of industries within it can also impact index performance. US and Canadian indices, for example, do not always move in tandem. While both countries have large financial sectors, US indices also tend to be heavily weighted in Technology and Consumer Discretionary, while Canadian indices are more slanted toward Energy and Materials.
Currencies and Treasuries
Trading in currency and government bond markets is more sensitive to developments affecting the economy as a whole and less influenced by individual companies and sectors. Generally speaking countries with stable growing economies tend to attract higher capital flows.
In treasury markets for example, the interest rate is the benchmark used to rate the stability of countries. Traders demand countries considered to be riskier (whether because of economic volatility, national debt load or other factors) to pay a higher interest rate in order to compensate them for taking on more risk. Bond prices move opposite to interest rates so a higher interest rate means a lower treasury price.
Generally speaking, currency traders tend to base their trading decisions on monetary policy and economic strength. Because inflation and stimulative monetary policies undermine the value of paper money, currencies where the economy is stronger, inflation is low, the financial system is stable and monetary policy has the potential to be stable or tightened tend to outperform.
Currencies are traded in pairs, which involves being long one currency and short another. This means that GBP may perform differently depending on what currency it is being traded against. It could be climbing against the Euro, for example, while falling against the USD.
Economic Indicators and Markets
Each day countries from around the world publish data that moves the markets to varying degrees. The more important indicators include Gross Domestic Product, Employment, Retail Sales, Industrial Production and Monetary Policy Decisions. These numbers provide ongoing insight into economic trends and changes which can create trading opportunities.