Reading the environment
A central question in fundamental analysis is whether, and how much, a business is likely to grow or shrink. Execution by the company and its management matters, but so does the external environment, and economic analysis is how the analyst reads it.
- 1The GDP growth rate shows what is happening to the overall economy.
- 2Monetary and fiscal policy show whether policy supports further growth or not.
- 3Interest rates, inflation, public expenditure and the fiscal deficit show where monetary and fiscal policy are heading next.
Put together, these tell the analyst whether the economy is growing and whether the central bank and government want to support growth in the near term. If the economy is shrinking, the inflation rate shows whether the central bank has room to add liquidity by cutting rates, and the fiscal deficit shows whether the government has room to raise public spending. With that understanding, the analyst can judge how the economy's likely trajectory will affect the specific industry under study.
Three kinds of trend
| What it is | Duration | |
|---|---|---|
| Secular | Long-term change in the economy or an industry that displaces what is consumed or how it is produced | Occurs once in 7 to 10 years |
| Cyclical | Medium-term movement in the quantity of goods and services consumed; reverses, returns, reverses again | Cycles of 2 to 6 years |
| Seasonal | Highly predictable pattern in production and consumption | Annual, following the seasons of weather or agriculture |
Secular trends
Digitalisation of office space is the syllabus's example: consumption of paper and ink falls while spending on digital products rises. Secular trends are usually driven by disruption from technology, culture, demography and consumer preferences among other factors. They are long-term and often cause an inflection in an industry's business life cycle, which chapter 6 covers in detail.
Cyclical trends, at three levels
Cyclical trends are non-permanent and reverse over time. They appear at the level of the economy, of commodities and of inventories.
Expansion or boom: consumption rises on higher income, lower interest rates and high consumer confidence; high demand lifts production and employment, which keeps consumption high. Businesses plan capacity expansion, consumers buy long-term assets, both borrow, so borrowing and interest rates rise; consumption pushes inflation up as the economy nears its peak, and manufacturers add capacity expecting more demand.
Slowdown: at the peak, higher prices and higher rates discourage consumption, and the central bank may tighten to control inflation. Growth slows: consumption still rises but at a lower rate, and manufacturers who expanded see lower capacity utilisation.
Recession: with utilisation low, manufacturers cut expansion plans and begin layoffs. Unemployment rises, incomes fall, consumption falls, losses and more unemployment follow, and the cycle sustains falling consumption. Consumer confidence declines; people save rather than borrow or spend, so interest rates fall and lower consumption brings inflation down.
Recovery: low inflation lets central banks loosen monetary policy and extend liquidity. With money easily available and prices lower, consumers start buying, activity picks up, and expansion eventually returns.
The economy keeps moving through these phases, but the length of each is unpredictable. Understanding the cycle gives the analyst a medium-term outlook on sales volumes and prices for an industry.
Rates and inflation rising: expansion heading to its peak. Rates high and utilisation falling: slowdown. Rates and inflation falling with layoffs: recession. Policy loosening and demand returning: recovery. Match the description's direction of rates and inflation before anything else.
Prices of many hard commodities rise and fall in cycles, mostly driven by the economic cycle: up in expansions on demand, down in recessions. But a commodity cycle can also run independently. High prices tempt suppliers to add capacity; when many do, prices fall; high-cost producers find operations uneconomic and abandon capacity; supply shrinks; prices rise again.
The inventory cycle is a short-term cycle inside the commodity cycle, driven by stock adjustments. Customers holding large inventories temporarily cut procurement, stock piles up at suppliers, prices fall. In a downturn cautious customers cut procurement hard; if demand for their products improves even marginally they lack stock and must buy immediately, and prices rise. The syllabus's example: in April 2020 huge crude inventories in Oklahoma crashed crude futures to around USD 20 a barrel and briefly negative; as the inventory position improved, futures traded around USD 40 a barrel by June 2020. Understanding the inventory cycle helps forecast near-term demand and prices for a business's inputs and outputs.
Seasonal trends
Seasonal fluctuations are highly predictable because of their nature: agriculture's contribution to GDP is higher around harvest, so agricultural income varies quarter to quarter with the sowing and harvest cycle. Analysts must factor seasonality into any trend. Economists use seasonally adjusted growth rates; a simpler tool is year-over-year growth, comparing a period with the same period of the previous year. The assumption behind it is that the observable and unobservable factors that influence a metric in a given period recur in the same period each year.
- Economic analysis reads the external environment: GDP growth for the overall economy, monetary and fiscal policy for whether growth is supported, and interest rates, inflation, public expenditure and the fiscal deficit for where policy is heading. Low inflation gives a central bank room to cut rates; a small deficit gives the government room to spend.
- Secular trends are long-term changes, once in 7 to 10 years, driven by technology, culture, demography and consumer preferences, and they displace what is consumed or how it is produced (digitalisation cutting paper and ink). Cyclical trends are medium-term, reverse and return, in cycles of 2 to 6 years. Seasonal trends are highly predictable annual patterns following weather or agriculture.
- The economic cycle has four phases: expansion or boom (higher income, low rates, confidence, capacity expansion, rising borrowing, rates and inflation), slowdown (high prices and rates and tighter policy slow growth, utilisation falls), recession (expansion cut, layoffs, unemployment, falling consumption, falling rates and inflation), recovery (low inflation lets the central bank loosen, cheap money and lower prices revive buying).
- Commodity cycles usually follow the economic cycle but can run on their own through capacity responses; inventory cycles are short cycles inside them driven by customer and producer stock adjustments (crude around USD 20 and briefly negative in April 2020, around USD 40 by June 2020). Seasonality is handled with seasonally adjusted rates or year-over-year comparison.