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Economic forecasting and financial markets

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Economic forecasting and financial markets are closely intertwined as the results of one can significantly impact the other. A financial market is a place to exchange financial assets, be they securities like equities or bonds, commodities, derivative products, or more.

Financial Markets

Financial markets are independent entities with their own influence on growth, interest rates, inflation, and foreign exchange rates. Private markets exist for credit, goods, and foreign exchange. Each market has its own set of supply and demand factors, prices, and exogenous forces. These market factors evolve and so do their influence on any business—private or public—and their economic activity. Changes in these factors alter market prices for interest rates independent of any action of the Fed, and drive economic growth, inflation, and exchange rates.

There are a number of key financial markets: foreign-exchange, money, equity, securitization, fixed-income, futures and options, and other derivative markets. Each of these allows for the exchange of different types of financial instruments be they stocks (in the capital or equity market), bonds (fixed-income market), credit default swaps (derivative market), calls and puts (option market), or currencies (foreign-exchange).

Financial markets have significant impact over global and domestic economies. They serve as underlying price-setters for consumer goods like gasoline, hold sway on the value of a company’s equity and debt, and allow for both prosperity via investment and crisis via risk.

Economic Forecasting

In isolation, the statement that a company’s sales are up 5 percent is meaningless. Five percent compared to what? Up over what time period? Are those real or nominal sales? The importance of aggregate economic concepts such as the gross domestic product (popularly termed GDP), real final sales, consumer spending, and business investment is that they provide a benchmark for analyzing an institution’s performance over time. A company whose sales are growing 5 percent while the economy’s nominal growth is 8 percent is likely losing ground. In contrast, a company growing 5 percent while the economy is growing 3 percent is gaining share. Over the last 60 years, the private and public institutions in America have developed a wealth of data for analyzing the economy as it stands and forecasting future results. Here are a few such data points:

Gross Domestic Product

GDP is the most simple and standard benchmark for gauging the performance of an overall economy, public policy, and the relative success of any enterprise. This measure allows decision makers to answer several key questions: How is the economy growing relative to the past or the promises of the future? How is the economy performing relative to the promises of the current political leadership? How is my company or institution growing or shrinking relative to the overall economy? Gross domestic product, as prepared by the Bureau of Economic Analysis (BEA) of the United States Department of Commerce, measure the total market value of final goods and services produced in the United States during a certain time period and is therefore a summary measure of the economic process.

Inflation

The term inflation is used often in a way that does not accurately represent the real concept of inflation. Inflation is a rise in prices of a large number of goods and services. The price of an individual good may rise, but that is not inflation. There is no inflation in oil or gold prices, there are price increases. For strategic thinking, price increases in individual goods such as oil, gold, and wheat are relative price changes that signal opportunities for the seller and cost increases for the buyer.

Inflation’s benchmark has traditionally been the consumer price index (CPI) because this series has a long history. The CPI is used extensively in many contracts today for private sector collective bargaining and payments to Social Security recipients and the military and civilian retirees of the federal government. The CPI measures over time the cost of goods and services purchased by the consumer compared to a base period. CPI measures price changes for a fixed basket of goods, but since no substitution is allowed there is a tendency to overstate price changes over time. An estimate is made of the significance in the typical household budget for each major category in the index. Different major categories have different weights in the CPI. For example, food represents 13.7 percent while movies represent 0.14 percent of the household budget.

Interest Rates

Interest rates are the rate at which interest is paid by a borrower on a loan from a lender, typically expressed as an annual percentage of the principal amount. The Federal funds rate and the Treasury rate are the central drivers of interest rates, along with the incentives that come from the yield curve—the difference between the yields on 10-year rates less 2-year Treasury yield. The Federal funds rate is the interest rate that banks charge one another for overnight loans. The Federal Reserve sets the rate, which then serves as the benchmark for the cost of funds to the banking industry and, thereby, the rest of the economy. The Federal funds rate, along with its first cousin, the discount rate,7 is an administered interest rate and thus it is not determined primarily in the open market.

Exchange Rates

Exchange rates, especially the dollar, euro, and yen, have many relatives. The dollar’s exchange rate value can be compared to many different currencies and for many businesses these bilateral exchange rates are often of primary importance.

There are many other economic indicators used to compile economic forecasts, including but not limited to, unemployment data, consumer confidence, housing starts, industrial production, bankruptcy, retail sales, and more. Economic forecasting involves making predictions about the future of the economy based on this and other data. Banks, corporations, financial institutions, regulators, governments, and independent associations all make separate and distinct macroeconomic forecasts to better inform themselves and their fiduciary responsibilities or the general investing public. The financial markets these data help render understandable are sensitive to economic forecasts and new economic data and will often move as reports and forecasts are made.

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Article copyright 2011 by John Silvia. Reprinted and adapted from Dynamic Economic Decision Making: Strategies for Financial Risk, Capital Markets, and Monetary Policy with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes as well as changes in supply and demand relationships, interest rates, monetary and other governmental policies or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.

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