Economic Analysis: The First Step in Fundamental Analysis
Before diving deep into a company's financial statements, smart investors first look at the economy as a whole. Even a great company can struggle in a weak economy, while an average company may perform well during a strong economic cycle.
The idea behind starting from the economy is that we are going to use a top-down approach, which we have already studied in our previous post. Here we start from the economy – then study the industry and lastly analyse the company.
Today, we will cover the economics part.
What is Economics?
Economics is the study of how people make choices under conditions of scarcity and the impact of those choices for people at an individual level and society at a macro level. Economic analysis of human behaviour begins with the assumption that people are rational – they have well-defined goals and try to achieve them as best they can. In trying to achieve their goals, people normally face trade-offs – resources, both material and human, are limited, and making one choice would generally mean letting go of something else. It requires prioritisation of needs and wants and allocation of limited resources to the desired goals.
Although there are several branches of economic study, microeconomics and macroeconomics are the most well-known. Let’s deep dive into it.
Microeconomics
Microeconomics is the study of the behaviour of individuals and their decisions on what to buy and consume based on prevalent prices which in turn signals where the economy will direct its productive activities. Microeconomics deals with the understanding and working of consumers, producers, resource markets and humans under various assumptions of market structures. Microeconomics helps us understand how the prices of the products and services get determined in an economy, how individuals and firms behave related to those prices and how goods and services in an economy are distributed among its various participants.
Macroeconomics
macroeconomics is the study of "the big picture" in the economy. the focus of macroeconomics is on factors that influence aggregate supply and demand in an economy such as unemployment rates, gross domestic product (GDP), overall price levels, inflation, savings rate, investment rate etc. Most of these factors are affected by changes in the public policies.
Macroeconomics helps us understand the general state of the economy – Domestic Production, Domestic Consumption, General Price levels, Growth, Quality of life etc.
Microeconomics vs Macroeconomics -
Microeconomics studies individual decision-makers –
How does a single consumer decide what to buy?
How does a single company decide how much to produce and at what price?
How do supply and demand for one product move together?
Macroeconomics studies the economy as a whole.
Gross Domestic Product
Inflation
Total employment, interest rates, government spending, and trade
Key economic variables that impact the Economy -
These are the numbers that move markets. We don't need to track all of them daily, but knowing what they mean helps us understand market moves and news headlines.
GDP - GDP is the market value of goods and services produced within a country’s frontiers, irrespective of the nationality of the owner who produces rising GDP indicates growing economy which is generally a good sign for a country and stocks.
Inflation - Inflation is defined as the general increase in price levels of goods and services in the economy leading to an erosion of purchasing power of money. High inflation depletes company's margins and consumer spending power. For example, if you put 100 rupees today in a drawer, after one year it would be same, but it would buy less goods and services than one year before.
Interest Rates - The repo rate or interest rates are set by the RBI. The Higher interest rates make borrowing costlier for companies and consumers, which can lead to slow down the growth of the companies, but it can help in controlling inflation.
Fiscal Deficit - It is the gap between government<s earnings and spendings. High fiscal deficit can be interpreted as more government borrowing, which can lead to increase in interest rates.
Current Account Deficit - Current account deficit is the difference between what a country imports in comparison to exports. It also affects the value of the rupee.
Unemployment Rate - Unemployment rate refers to the eligible and willing to work unemployed population of the country in percentage terms. During a slowdown in economies, unemployment rate rises and during an expansion phase, the unemployment rate falls as more jobs are created as production goes up. Reflects how much spending power people in the economy actually have.
Trends in Economy -
Economic Trends can be classified into three parts -
Cyclical Trends
Secular Trends
Seasonal Trends
Cyclical Trends -
Not every economic trend behaves the same way, and mixing these up is a common investing mistake. cyclical trends are non-permanent trends that reverse over a period.
Cyclical trends can be observed at many different levels -
a) Economic cycle - It refers to the typical process an economy takes to go from expansion to recession and back.
b) Commodity cycle -. Most often the commodity cycle is driven by economic cycles. During expansionary phase, commodity prices tend to go up driven by increased demand and the prices tend to fall during recession.
c) Inventory cycle - Inventory cycles are short term cycles that occur within a commodity cycle. These occur on account of inventory adjustments by producers and customers.
Examples of Cyclical Trends -
Auto sales, steel demand, and cement consumption typically rise during economic booms and fall during slowdowns.
Secular trends -
secular trends are long term trends that cause displacement in production or consumption of goods and services.
There are various factors that drive secular trends -
· Advancement in technology
· Change in Income level
· Demographic Changes
· Regulatory Changes
Example: The shift toward digital payments, or rising internet penetration in India, is a secular trend - it keeps growing regardless of whether the economy is in a boom or a slowdown this particular year.
Seasonal trends -
Seasonal trends are highly predictable trends fluctuations in the quantity of goods and services being produced or consumed, owing to their nature. For example, GDP contribution from agriculture is likely to be higher around the period of harvest. Therefore, agricultural income will vary quarter over quarter based on the sowing and harvest cycle.
Now the question is where to find this data?
The data regarding economy published time to time by the government and from other sources mentioned below -
RBI (Reserve Bank of India) - interest rates, monetary policy, inflation reports
MOSPI (Ministry of Statistics and Programme Implementation) - GDP, IIP, CPI data
CSO (Central Statistics Office) - National income and GDP estimates
Ministry of Finance - Union Budget, fiscal deficit numbers
World Bank / IMF - global comparisons, growth forecasts
Commerce Ministry - trade and export-import data
We can find the data from various broking apps like First Demat and financial news platform where these platforms aggregate all the information.
Why Economic Analysis is important in Fundamental Analysis?
Fundamental analysis tries to answer one big question - will the business grows or shrink in the future? Mostly it depends on the company itself - its management, decisions, and execution. But no company works in isolation, and every company is exposed to economy. This is where we need to do economic analysis.
Economic analysis helps us to understand how the outer environment can affect the business.
Here is how we can predict -
By Looking at GDP growth - GDP tells us how fast the economy is growing. If GDP of India is growing well, businesses get more customers, more demand, and more opportunity to expand.
Look at monetary and fiscal policy - Monetary policy and fiscal policy tell us if the environment is supportive of growth or not for the businesses.
By Tracking key numbers -
A few numbers can help us in guessing where policy is going to headed next -
Interest rates, Inflation, Public expenditure, Fiscal deficit
By tracking these, we can guess two things -
Is the economy growing, and do the RBI and government want to support that growth further?
If the economy is slowing down, do they have room to help it recover?