“I dodged a bullet last year by learning about macroeconomics and reducing my holdings in the growth fund.” Matt was one of a group of managers discussing their latest IRA report at lunch. Each had invested their contributions in a high-growth fund available through their employer, a Dallas-based engineering firm. Since the first of the year, the value of the fund had fallen by almost 25%, and predictions of a coming recession filled headlines and social feeds.
“How did you know to do that? a listener asked. “I keep up with financial news and I know you find differing opinions on everything. Who warned you to get out?”
“No one. I decided for myself, “ Matt replied. “Last year during Covid, I got tired of watching television and browsing the internet all day and began reading investment books. I learned about some economic indicators that professionals use to predict whether the economy will go up or down. Before I started studying, I never knew how much the government affects almost everything. I won’t make that mistake again.”
Most people are like Matt, not realizing that economic circumstances drive government decisions that affect America’s production, jobs, and the prices we pay for groceries and gasoline. As Matt noted, individuals do not make those kinds of decisions, but they are affected by them.
Table of Contents
Macroeconomics is the study of components of a country’s production and consumption. In simple terms, macroeconomics is about who produces products and services and who consumes them. All economies experience cycles of boom and bust. During booms (periods of growth), the nation’s Gross Domestic Product (GDP) – the total value of the nation’s goods and services produced during a specific period – is growing. Companies are profitable, well-paying jobs are plentiful, and the stock market values climb. During a bust (period of decline), production, profits, and employment generally fall. The stock market makes an abrupt change from Bull to Bear. Times are hard until the next boom cycle begins.
Macroeconomic Leading Indicators
Through his study, Matt learned about several measures that seem to be trusty indicators of future economic conditions, especially when they collectively suggest the same outcome. Knowing when a boom cycle is beginning or ending is valuable information. The leading indicators are more real-time indicators of what’s truly happening in the economy. Useful indicators of future economic conditions are:
- Durable Goods Orders. The U.S. Census Bureau’s monthly index measures business orders for new equipment and machinery. When businesses believe that the market will continue to grow, they replace old equipment, expand facilities, and invest in new technology. When they worry that a slowing of their sales and falling profits are likely, they bolt down the hatches by repairing their equipment, discontinuing projects, and hunkering down to save cash until the storm has passed.
- Manufacturing Jobs. Like durable goods orders, companies add to their workforces if they expect growing sales. When they stop hiring, they expect that growth will slow or fall. The Bureau of Labor Statistics (BLS) Labor Report indicates whether manufacturing firms are hiring, reducing headcount, or sitting pat.
- Building permits. Data about new home construction is available as a U.S. Census monthly publication. Falling permit volume indicates there will be few customers for new homes 6 to 12 months ahead and vice versa. Home construction is a significant contributor to GDP.
- Treasury Yield Curve. The U.S. Treasury publishes a daily report comparing the returns of short-term Treasury bills to long-term Treasury bills and notes. In normal circumstances, short-term rates have lower yields than longer maturities. A Treasury Yield Curve Inversion – a situation where short-term yields are higher than long-term yields – has preceded each recession since 1970.
- Stock Market. A broad stock market index like the S&P 500 represents investors’ expectation for the stock market in the short to medium term. A falling (Bear) market indicates that fear and uncertainty cause people to liquidate positions and withdraw from stock investing. Conversely, a rising (Bull) stock market suggests Investors are positive about future corporate profits and rising stock values.
- Consumer Confidence. The monthly report from The Conference Board, a nonprofit business think tank, presents data from polls of U.S. consumers about the current state of business and market and their expectations of the short-term future.
Matt explained how he compared the various indicators over several months, easily available on the Internet. For most of 2021, the trends of most leading indicators were positive, except for Consumer Confidence. Expectations for a possible recession appeared in mid-2021.
Unsure whether the index was an outlier or an early indicator of coming trouble, Matt kept investigating, especially watching several lagging indicators that were used by the Federal Reserve to determine fiscal policy.
Macroeconomic Lagging Indicators
Some macroeconomic measures reflect current economic decisions, and their outcomes confirm the prediction of leading indicators. Three lagging indicators (takes additional time to catch up to real-time) are important since their interpretation leads to direct government action:
- Gross Domestic Product (GDP). This indicator measures the health of the nation’s economy. A rising GDP generally means the country is doing well. The U.S. Commerce Department’s Bureau of Economic Analysis reports the information quarterly. For most of the past 50 years, the U.S. has enjoyed rising GDP, excluding brief periods of slow or negative growth.
- Consumer Price Index (CPI). This index, provided by the Bureau of Labor Statistics, measures changes in price of a “basket” of goods and services typically purchased by an average American. The basket contains food, clothing, shelter, utilities, medical care, and other necessities. The price of the basket rises and falls, reflecting the price changes of the individual items in the basket. The CPI is a measure of inflation or a general fall in the purchasing power of money.
- Unemployment rate. The rate, calculated monthly by the Bureau of Labor Statistics, is a percentage measure of people living in the United States aged 16 years and older who are seeking jobs but remain unemployed. Excluding the layoffs due to the Covid pandemic, the country has enjoyed full employment for more than five years.
Matt discovered that the CPI had exceeded 4% in June 2021 for the first time since 1991. He knew that prices in his community had begun to rise. If so, the Federal Reserve would certainly act, he reasoned. That would mean higher interest rates that could end in a recession.
The Role of the Federal Reserve in the Economy
The Federal Reserve System (FED) – America’s Central Bank – manages the economy through fiscal policies. Established in 1913, the FED is an independent government agency responsible for the stability of the United States financial system. The agency operates under a Congressional mandate “to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.” Its collective actions directly impact the expansion or retraction of the country’s Gross Domestic Product (GDP) and the rates of inflation and employment.
Scope of FED Actions
Understanding the factors that cause the FED to act and the subsequent consequences of their actions is critical to be proactive in the preservation and building of personal wealth.
To accomplish its mission, the FED utilizes four major tools:
Setting the Federal Funds Rate
Short-term rates generally affect long-term rates with corresponding moves up or down, i.e., when short-term rates rise, long-term rates typically rise, too. When Fed Funds rates rise, borrowing costs are higher, discouraging the use of loans by individuals and businesses. Conversely, lowering the Fed Funds rate increases the availability of borrowed funds, encouraging investment and consumption. Most of us Millennials have lived through a time of aggressively low interest rates. Post 2008 Financial crisis, the FED has lowered the interest rates to the lowest level in history in order to stimulate borrowing and economic growth. These last 10+ years have seen an unprecedented amount of wealth creation simply due to low interest rates and increased expansion of the money supply. But now this expansion of the money supply has caught up to us in the form of high inflation.
Establishing Commercial Banks’ Reserve Ratios
The FED establishes the reserves that banks must maintain free of claims to secure its liabilities. The loans made to businesses and individuals by the bank are assets of the bank, not liabilities. Raising and lowering the reserve requirements affects the volume of loans that a bank can make. In response to the Covid pandemic, the FED set the reserve requirements at 0% on March 26, 2020.
Expanding and Retracting of the Nation’s Money Supply
The FED Open Market Committee also expands and retracts the nation’s money supply through its purchases and sales of U.S. Treasuries. When they buy Treasuries, money is deposited in banks, which creates extra reserves and encourages more loans. When they sell Treasuries, bank deposits fall, reducing the banks’ reserve and curtailing loans.
“Jawboning”
Since FED actions have major impact on the economy, the announcement of potential acts can have the desired effect. In other words, a warning of potential acts can accomplish the FED’s intent without having to act. Consequently, economists and astute investors regularly follow the FED’s minutes, press releases, and public speeches.
Causes for FED to Take Action
Due to the dual mandate, the FED reacts to high inflation or unemployment. Feeling that a “little inflation”- 2%-3% annually – stimulates GDP growth, the FED usually acts when the CPI rises above the targeted 3% level. Similarly, unemployment above 5% will trigger a FED response. When inflation and unemployment are at acceptable levels, the agency generally takes no action.
The FED rarely reacts to short-term events, typically waiting to confirm a trend before taking remedial action. Furthermore, the FED usually announces pending moves days, even weeks, before acting. The delay allows individuals and businesses to take proactive steps before the FED acts.
Using Macroeconomic Data to Your Advantage
Understanding an economy’s cycle of boom and bust enables a person to make better financial decisions with investments, lifestyle, or business management. Multiple advantages accrue to those who understand macroeconomics and what they represent:
Better Investment Decisions
With the advantage of using econometrics, Matt reduced his holdings in the high growth fund and diversified his portfolio with high-yield, low-cost ETFs, Real Estate Investment Trusts (REITs), and money market funds (cash equivalents with low interest). He keeps the money market funds in reserve for purchasing when the FED lowers rates to promote growth. When other indicators – such as the Treasury Yield Curve inversion, which appeared in March – confirmed his analysis, he was sure a recession would occur in late 2022 or 2023.
Use of Leverage
If you can anticipate the direction of interest rates, you can borrow or pay off debt when it is most advantageous. For example, the difference in home mortgage payments can be hundreds of thousands of dollars.
Borrowing money should be avoided during rising or high interest rates since the economy naturally slows, business and personal incomes tend to stagnate, and the prices of goods and services increase to cover the higher rate of inflation and interest. Loans with variable rates should be repaid before rates rise.
Personal Budgeting
When inflation rises, prices of goods and services naturally go up as businesses attempt to preserve their profit margins. If the FED takes aggressive action to reverse inflation, recessions can occur. As rate increases slow or reverse revenue growth, companies typically pursue more aggressive cost-cutting, including furloughs and terminations.
When econo-metrics suggest that the FED will take adverse actions to slow inflation by raising interest rates, you should take steps to protect your assets and lifestyle. You might consider postponing luxuries, deferring large purchases, and increasing savings to limit the impact of possible wage cuts or layoffs. If you have variable interest loans you should quickly find ways of reducing the principal amounts, pay off the loan or refinance to a fixed rate.
Business Management
Being forewarned is forearmed. Looking beyond local markets and competitors is critical for company owners. During boom times, competitors flourish, adding staff, introducing new technologies, and seeking new customers. But businesses are most vulnerable when economies shrink. Strategically, the time to expand is when your competitors are least prepared. Staying abreast of economic indicators enables companies to prepare for growth at opportune times.
When indicators predict slower growth and higher interest rates, business owners should defer new investments and hires, pay down debt, and increase savings to weather poor economic conditions – getting ahead in this can also be looked at as a competitive advantage.
Conclusion
Television and print editors are masters at using sound and fury to capture attention. Heavy black headlines warn of manufactured catastrophes: runaway inflation, recessions, unemployment, and investment losses. To calm growing fear, government leaders respond with comforting assurances that claims of economic disasters are exaggerated and unwarranted.
Investors and business owners are caught in a confusing, often contradictory deluge of opinions. Understanding macroeconomics allows a person to do their own research and use their judgment for the best path to take.
As the lunch hour ended and the managers began to return to work, Matt had the last words:
“I may have been a little early selling the growth fund, but it was clearly the right decision for me. I’ve lost a little, maybe 5% of the portfolio’s value, but I am a lot better off than most investors. I’m getting more dividends and rent distributions than before, I have money in my account to buy bargains when the FED starts to boost the economy, and I sleep well at night,” explained Matt. “I wish I had told your guys what I learned, but I wasn’t sure I was right until later. Sorry.”
“Just tell us when you think the market will go up and we’ll forgive you,” growled Tyler, a manager in the Purchasing Department. “And you might give me the names of the books you read about macroeconomics.”