Fundamental analysis is the ability to assess an asset to try and determine its intrinsic value. It relates to one of the tents of Dow in the fact that anything can affect the price of an asset and ultimately is reflected in the price.
It is the study of macroeconomic factors (economy conditions) and microeconomic factors (financial conditions). There will be lots of different areas to study depending on the market however it is all interlinked.
This is the data that helps explain an economies general health and is what governments often use as indicators on progress within a country. It is also used by analysts to try and determine the underlying value of certain markets.
It offers data including inflation, price levels, growth, national income, gross domestic product (GDP) and changes in employment. There are lots of indicators that can give you an idea about how a market is performing. We look at some of the major measures that are significant when analysing an economy or market.
For up to date data see tradingeconomics.com.
Gross Domestic Product (GDP)
GDP is arguably the most important of all economic statistics as it attempts to capture the state of the economy in a single number.
- If the GDP measure is up on the previous three months, the economy is growing
- If GDP is negative (negative growth), the economy is contracting
- Two consecutive three-month periods of contraction mean an economy is in recession
In theory all three approaches should produce the same number.
In the UK the main point of interest is the quarterly change in GDP, that is after taking into account the change in prices (inflation).
Calculating a GDP estimate for all three measures is a huge undertaking every three months. It involves surveying tens of thousands of UK firms. The main sources used are ONS serveys of manufacturing and service industries.
Information on the sales data is collected from:
- 6,000 manufacturing companies
- 25,000 service sector firms
- 5,000 retailers
- 10,000 construction companies
- Government departments covering activities such as agriculture, energy, health and education
The UK produces the earliest estimate of GDP of the major economies, normally around 25 days after the quarter. The provides policymakers with an early estimate of the real growth, it’s quick but it only based on the output measure.
At this stage only 40% of data is available and so the figure is revised when more information comes in. Revisions an be made 2 years after the first estimate is published. For more information on the process see the ONS website.
Inflation is one of the most important issues in economics since it provides a measure of the change in the prices of goods and services we buy. The inflation rate influences a wide range of day-to-day issues:
- Saving interest rates
- Mortgage rates
- State pension levels
- State benefits levels
- Price changes of some train tickets
Inflation – CPI and RPI
Inflation is the rate of change of prices for goods and services. There are a number of different measures of inflation in use. The most frequently quoted and most significant ones are the Consumer Prices Index (CPI) and the Retail Prices Index (RPI).
Each of these looks at the prices of hundreds of things we commonly spend money on, including bread, cinema tickets and pints of beer, etc and tracks how these prices have change over time.
The inflation rates are expressed as percentages. If CPI is 3% this means that on average the price of products and services we buy is 3% higher than a year earlier. In other words, we would need to spend 3% more to buy the same things we bought 12 months ago.
RPI includes housing costs such as mortgage interest payments and council tax, whereas CPI does not, but that only accounts for a small part of the difference between RPI and CPI. The main difference is caused by the fact that, although they use much of the same data, they calculate the inflation rate using different formulas.
Importance of Inflation
Researchers track the prices of thousands of items we regularly put into our shopping baskets. Tracking this data gives governments and central banks an insight into how the economy is performing and ultimately helps them set economic policy.
Central banks will use it to help them set interest rates. In the UK, if the BoE thinks that inflation will go above 2% over the next two years it may increase interest rates to try and subdue it.
On the flip side, if it thinks inflation is likely to be below 2%, it may look to cut interest rates to try and give the economy a boost. This is why inflation rate is crucial in determining the rates the banks charge for mortgages and the rates they offer for savings accounts. Ultimately having a direct impact on peoples incomes. Should someone have to pay more in mortgage repayments then they will have less money in their pocket to spend on other items.
Some companies use the level of inflation to set annual pay rises.
These are two of the biggest macroeconomic measures that affect the financial markets, especially the Forex market. However there is a huge amount that can affect the markets. Political risk is also something that can play a major role in market movements. This can be anything from policy to war!
Grasping an understanding of the wider picture is hugely important and although you cannot learn everything immediately, the best way it to continues to read up on current government and central bank stances and what are the factors that they continue to refer to that affect their decision making.
Getting this understanding can give you an idea of the intrinsic value of the market and you can decide if the market is undervalued or not. If so, then it would be a signal to buy that market.