Is The Economy Healthy – How Experts Read an Economy

Posted on: 18/05/2020

Raffi Pailagian
MBA, BSc, DipFP
Financial Planner / Managing Partner

Categories: Financial Planning & Advice Holistic Planning & Advice Investing Wealth Management

Is The Economy Healthy & How Can You Tell ?

An economy can be a little bit like a house of cards. Every element is dependent on the strength and movement of the others, one little twitch can bring the whole lot down. But there are some key indicators Economists use to read an economy which will help you understand its underlying strength, its likely investment potential and importantly is the economy healthy.

4 Key Factors & How To Read Them

There are four key factors that economists will look at when evaluating an economy:

GDP
Interest Rates
Inflation
The Labour Market

The relationship between these factors is vital for maintaining balance in the economy, as each one will have impact on the others.

GDP

Gross Domestic Product (GDP) is the dollar value of all goods and services produced by a country measured over a time period, usually quarterly and yearly. When compared to the previous year’s GDP, you can gain a quick snapshot of how an economy is doing, the higher the number the more the economy is growing. That said, an explosive GDP can cause hyperinflation, so there is a balance.

This metric is also used to determine if an economy is in recession, which is considered to be two negative quarters[i]. In Australia economists like to see a GDP growth of at least 2% to account for the growing population.

Consumer spending accounts for around 2/3 of GDP, and a small change in spending habits can have a significant impact GDP. When there is a drop in the stock market, people perceive they are less wealthy, and spending slows. This impacts the GDP, which in turn puts more pressure on the value of the stock market. And so it goes on. This phenomenon is known as ‘The Wealth Effect’.

You can see that the GDP can have significant impact on investor sentiment. Investors are generally prepared to pay more for stocks when the GDP is rising, as they see the economy is improving, but if GDP is in decline there will be a perception stocks are worth less.

Interest Rates

Higher interest rates moderate economic growth by reducing disposable income and limiting consumer spending, thereby slowing the economy and reducing inflation. Asset prices reduce along with consumer confidence. Lower interest rates encourage borrowing, thereby increasing inflation and stimulating demand. Asset prices increase and people feel wealthier.

Interest rates are used by central banks, in Australia it is the Reserve Bank, to manage inflation.

Inflation

Balancing inflation is key to economic stability. If inflation is too low, it can lead to stagnant wage growth and increased unemployment. However, if inflation is too high purchasing power and the real return on investments is reduced, it can also lead to higher wage growth, which further increases inflation.

Most countries measure inflation or deflation based on a CPI (Consumer Price Index). Many economists also look at the ‘output gap’, the balance between supply and demand in an economy.

The Reserve Bank of Australia uses interest rates to help control inflation, preserving the value of money and encouraging long term sustained growth.[ii] An inflation rate of 2-3% is the targeted sweet spot in Australia. Simplistically put, when inflation is too high, interest rates are increased to reduce spending, when inflation is low, interest rates are reduced, to stimulate spending.

The Labour Market

The Unemployment Rate is inextricably linked with both inflation and GDP. There is a ‘natural’ level of unemployment that allows for flow between changes in industry and seasonality. If unemployment drops below this natural level, inflation increases as do wages.

The RBA consider 5% to be the ‘natural’ level of unemployment in Australia, but recently some economists have come to believe it could drop as low as 4% without impacting wages growth[iii].

That House of Cards

And then there are the wild cards. Things like unexpected political turmoil, extreme weather events, even worldwide virus events can take a previously stable or flourishing economy and give it a good knock.

The trick is being able to identify whether these unexpected events are short or long term problems, and what industries or companies might prosper in these circumstances. This is where the advice of an experienced Financial Advisor is invaluable in knowing when to hold firm and when to exit the field.

If you would like to chat with us about reading the economy and how this could help you achieve your financial as well as life goals, please contact us on 02 9976 3388 or click below and we’ll be in touch: