How do investors paint a picture of economic health?

Lens 1 – Income

Component 1 – Employment

For most countries, using the labour force to its full (or close to full) economic potential is vital. Two of the most important things informing the state of employment are payroll and the unemployment rate.

Payroll reflects the level of employment in an economy that can generate income for households. The income earned by the employed can be spent on goods and services, used to reduce debt, or it can be saved/invested. 

In the US, for example, ‘non-farm payrolls’ is a very closely watched number. It is released monthly and shows how many jobs have been added to the national payroll that month. It does not include farm labour jobs, because these can be highly seasonal. Nonetheless, non-farm payrolls captures about 80% of people contributing to GDP according to the Federal Reserve Bank of St Louis – one of the regional Reserve banks in the US’ Federal Reserve System.

The unemployment rate is the percentage of the labour force that is without a job. This is one of the ‘imbalances’ we will explain later in the guide. Unemployment can change for several reasons, but if it rises, it is seen often as an indication that an economy is weakening; for example, because businesses are having to reduce costs due to lower sales.

Economies tend to be expanding when employment grows and the unemployment rate falls. Employment growth then is often seen as a sign of business confidence.

Component 2 – Wages

Growth in wages can impact consumer spending and investing.

Consumer spending is important for the economy, as it supports other jobs through the generation of sales of goods or services.

Higher wage growth can drive savings as well as consumption. Savings can be channelled through investment to support companies looking to grow. In turn, as companies grow, they can create new jobs and goods/services that can reinforce a positive cycle.

Of course, the opposite is also true. If wage growth stagnates or falls, or even if wages don’t keep pace with inflation, it can cause a knock-on effect which can hurt employment and consumer spending.

Wage growth above inflation is generally welcome, as consumers become wealthier in what is called ‘real terms’. Real wage growth can lead to more spending and investing. However, if wages grow too far above inflation, it can dampen productivity (how efficient an economy is) as more company resources are directed at wages compared to investment in machinery and equipment. We explain more about why inflation can hinder economic stability later in the guide.

In services industries, wage rises tend to have a bigger impact on overall price growth. As such, service price inflation can have a larger effect for economies that are more skewed towards the service sector (such as the UK and the US economies). Germany, in contrast, has a more manufacturing-led economy.

Component 3 – Corporate profits/earnings

Corporate profits are typically referred to as ‘earnings’ in the investment industry. Earnings are at the heart of stock market valuations, and while earnings growth is important, so too are expectations of earnings growth. Stock markets are happy to reward future earnings growth potential even if the growth is not guaranteed, and might take time to materialise.

Earnings – company profits – are either ‘retained’ on the balance sheet of the business or distributed to shareholders. If retained, the earnings can be spent on growing the business either via operational expansion (more of what they already do), investment in useful business assets, or even buying other companies. If distributed, profits can reach the wider economy via dividends paid to shareholders.

Lens 2 – Expenditure

Component 1 – Business investment

In addition to using retained earnings, company investment can be funded by borrowing money (debt). The level of interest rates in the economy will be a key driver of which of these options is chosen. As interest rates rise, borrowing becomes more expensive, so the debt side of financing becomes less attractive and may slow. If rates rise too much, it can, ultimately, slow growth.

Another aspect of the costs of investing in a new enterprise is regulatory cost. It is important that investors understand what in an economy is supported by things like government incentives, and what is self-sustaining.

Government industry policy can tilt the balance as to whether an investment is profitable or not. An extreme example of this is China’s subsidies of its electric vehicle (EVs) production and its renewable energy industry. In the case of EVs in particular, the extent of the Chinese subsidies ultimately created a significant issue with oversupply.

Different governments offer differing levels of industry support, but all effective governments apply safety, quality and reporting standards – an implicit cost of doing business.

Component 2 – Retail sales/household spending

Retail sales are reported monthly, and track the underlying direction of consumer spending. Auto sales are not included in retail sales data (they are reported separately), but all other ‘durable’ goods are included. Autos are another key data point for household consumption.

Goods are described in economic terms as durable or non-durable and this helps distinguish how consumers are spending. Both durable and non-durable goods can be split into more essential items versus discretionary items. Strong discretionary spending on durable goods is an especially strong sign of vibrant income and demand.

Component 3 – Housing investment

Home building and the purchase of existing homes generate different types of economic activity.

There is obviously a lot more spending and investment activity involved with the construction of a new home, with deeper and wider supply chains involved. However, moving into an existing home also creates considerable economic activity in service-producing companies. Estate agents, solicitors, surveyors, banks, and moving specialists are all employed, just as a few examples, as are companies that produce goods like paints, flooring, lighting and white goods.

Home purchase activity is one measure of economic mobility, along with employment growth. Demographic profiles of a population impact this too, with generational balance an important driver of economic mobility. For example, a population may have a higher proportion of older and retired people than younger people who are in the ‘build’ phase of financial security, which can slow housing market activity.

House prices are a key element of mobility of the generations. If the generation seeking to buy their first home can’t afford a house, economic mobility is constrained.

Lens 3 – Production

Production in an economy is the process of creating output that has economic value. Output is either of tangible goods – industrial production – or a service.

Components 1 and 2 – Industrial and service production

The industrial production side of an economy includes manufacturing, construction, mining and utilities (energy, water, communications). Industrial production data is widely measured and made available in developed economies.

The output (or production activity) of services industries is less well measured, but government statistics offices make attempts to account for this as best they can.

This mismatch in data-availability means economic commentators often focus on the industrial production cycle. To build a fuller picture of the strength of the service sector requires economists to compile elements of the three lenses of activity (income, expenditure, production).

Component 3 – PMI surveys

Purchasing Managers' Index (PMI) surveys are a perceived measure of activity. They are what economists call ‘soft data’; surveys of how managers believe their businesses are performing. However, they generally are considered more ‘forward looking’ than some economic data. Because they are based on surveys, they can capture the changing mood of an economic cycle.

PMIs include questions around activity levels, inventories, prices and orders, and if they are higher, lower or in line with the prior month. Expectations about the future are also asked but do not impact the headline result quoted in media and press releases. Because the surveys ask decision makers in companies directly about their company activity they can help to close the information gap between services, and the measured economic output of manufacturing. 

Lens 4 – Economic imbalances 

The momentum of economic growth can be self-perpetuating, provided imbalances do not arise to add friction. Two key imbalances that we keep an eye on are inflation and unemployment. Too much or too little of either may require policy intervention, which we explain below.  

Component 1 – Inflation

If inflation is too high, it can damage sustainable economic growth for several reasons.

For companies, inflation rises might lead the cost of materials and/or staff to rise, which can in turn reduce the company’s profits or flexibility to pursue growth strategies outlined earlier.

For consumers, higher inflation might mean essentials like food and fuel cost more, which eats away at disposable income. This diminishes their ability to spend on discretionary items which are often larger outlays and more economically impactful.

High inflation can be a warning sign that the economy’s resources are stretched. Too-low inflation is also a negative macroeconomic sign. It suggests that demand has not kept pace with supply. Japan for example, has struggled with too-low inflation for a long time, forcing the government into sustained monetary stimulus measures and limiting the options open to its central bank.

Governments and corporations both take a keen interest in understanding the reasons behind such imbalances and would aim to respond accordingly.

Monetary policymakers – like those at the Bank of England (UK) or Federal Reserve (US) – might ratchet up interest rates to bring inflation down or cut them to stoke demand. Companies may adjust pricing or, in the case of rising inflation, bring forward or suspend planned borrowing in anticipation of rising rates.

We look at overall inflation; as well as what is driving it, i.e. core inflation, goods inflation and services inflation. Core inflation is intended to provide an indication of long-term inflation in an economy, without the more changeable inputs of food and energy. Goods and services inflation figures determine how prices are moving in these two segments of the economy and, therefore, how established inflation is.

We also look for links between the prices of assets like stocks and bonds, and consumer prices (house prices especially) and we look at the links between wages, currency movements, commodity prices and consumer prices.

Component 2 – Unemployment rate

Unemployment being too high is another ‘friction’. Rising unemployment can be a sign of wasted labour resources and is also a sign of instability in the business or household sectors. It can cause monetary policymakers to cut interest rates, or it may trigger automatic fiscal policy ‘stabilisers’; both help retain economic resilience.

The major example of an automatic fiscal policy stabiliser to unemployment is social welfare payments. These ‘safety-net’ payments help to cushion the impact of unemployment on households and economic activity.

It should also be noted that some small level of unemployment is regarded by economists as necessary to enable minimum necessary mobility into new job openings. It can motivate retraining where workers are leaving industries at the end of their life-cycle (think combustion engines vs renewable energy transport).

Building confidence by considering all angles

Another way to think about the lenses described above is that they each provide a picture of an economy from a slightly different perspective.  

The pictures they provide might – indeed should – offer a broadly consistent view of economic health. If the pictures differ, it is the job of an economist or investor to determine why that might be the case. Looking at a range of data in this way helps investors to make decisions with greater conviction.