Fundamental Analysis

Fundamental Analysis: "The determination of price based on future earnings – it focuses predominantly on factors such as the overall state of the economy, interest rates, production, earnings, and management"

Fundamental analysis is a method of evaluating an asset; it attempts to measure its intrinsic value by examining the underlying forces that could affect the asset.

The Fundamentals

Supply and Demand

The factors that influence the prices of commodities, stocks, bonds and currencies can ultimately be attributed to Supply and Demand. The theory of supply and demand is the most fundamental economic principle that drives prices and explains consumer behaviors.

Law of Supply and Demand

Demand < Supply … Prices go down (recession)
Demand = Supply … Prices are stable
Demand > Supply … Prices go up (inflation)

Political News

In times of crisis or war, investors would usually buy a safe-haven currency (flight to quality) which has traditionally been the US Dollar. However, in recent years, the US Dollar seems to have lost its safe haven status and has been has been replaced by Gold and the Swiss Franc.

Market Expectations - "Buy the rumour, sell the fact"

It has been observed that prices tend to move primarily on expectations of certain events, economic data and political news rather than the actual data or news being released. Especially in the case of economic statistics, it is the expectation and the prediction of a certain condition in the economy that would drive prices up or down. Once the data has been released as expected, the markets usually tend to retrace after interpretation of the data.

Economic Factors

Economic dynamics are considered to be the main factors determining exchange rates in the financial markets. Economists gather data from various sources and compare them with economic statistics released by governments on a weekly or monthly basis. This data is thereafter analyzed and market participants base their trading decisions on the forecasts derived from the economic data. Traders who base their investment decisions on economic and other fundamental data are called "fundamental traders". The following is a brief list of economic indicators:

Interest Rates

Interest rates are considered the single most important economic factor determining exchange rates. The interest rate can be defined as the price paid for the use of money. Traditionally interest rate hikes in a country will lead to strengthening of its currency as investors shift assets to gain a higher return. Hikes in interest rates however also negatively affect the equity markets, leading to withdrawals from stocks and repatriation of funds out of the country, causing a weakening of a country's currency. Determining which effect dominates can be tricky, but generally there is a consensus beforehand as to what the interest rate move will do. Generally the timing of interest rate moves are known in advance and often take place after regularly scheduled meetings by the BOE, FED, ECB, BOJ, and other central banks

International Trade

The trade balance shows the net difference over a period of time between a nation's exports and imports. When a country imports more than it exports, the trade balance will show a deficit that is generally considered unfavourable. For example, when U.S dollars are sold for other domestic national currencies to pay for imports, the flow of dollars outside the country will depreciate the value of the dollar. Similarly if trade figures show an increase in exports, dollars will flow into the United States and appreciate the value of the dollar.

Money Supply

It is the total of money in circulation within an economy. Money Supply figures are gathered monthly and divided into various categories that include cash, time deposits, money market accounts, and short-term government securities.

Unemployment & Non-farm Payroll

The number of people in employment in the US is perhaps the single most important economic variable the Federal Reserve base their interest rate policy on. It is also regarded as the most important monthly report about the status of the economy, released on the first Friday of every month.

Unemployment Rate

Unemployment Rate is the percentage of unemployed workers within the working population. High unemployment is a major social problem due to lessening of living standards and personal distress. When unemployment is very high, it is considered as the major social and political issue.

Non-farm Payroll

Non-farm Payroll reflects the health of the commercial and industrial sector in an economy. It is the number of new people starting jobs in the non-agricultural sector. The size of this figure is positively related to the growth of the economy.

Gross Domestic Product (GDP)

Total value of goods and services produced in the economy over a particular period of time. The GDP growth rate is a primary indicator of the status of the economy. GDP is the broadest measure of economic activity.

Consumer Price Index (CPI)

CPI is a measure of prices at the consumer level for a fixed basket of goods and services. It is regarded as the most important measure of inflation. The relative expected inflation rate is a key factor affecting the expectation of changes in a country's exchange rate.

Producer Price Index (PPI)

The producer price index is similar to the CPI; it is a measure of prices at the producer level. It is the first inflation report that is released on a monthly basis.

Industrial Production

Industrial Production provides information about the goods producing sector of an economy. The indicator measures the amount of output from the manufacturing, mining, electric and gas industries.

Personal Income and Consumption Expenditure

Personal income represents the compensation that individuals receive from all sources including wages and other income. Consumption expenditures are funds spent by individuals on goods and services.

Retail Sales

This data provides a first indication of the strength or weakness of consumer spending for a given month. This figure however is volatile and sensitive of seasonal factors, thus does not have much impact on the value of the dollar.

In conclusion, economic growth is an increase in the production possibilities that result from an increase in resource supplies and efficiency. Moreover, it is an increase either in GDP or in the real output per capita. The inflation rate, the growth rate of output and the rate of unemployment are the three broad measures that judge the macroeconomic performance.

Central Bank Operations

Central Banks have several tools with which they can influence economic activity. Most Central Banks are concerned with inflation and price stability. The methods in which those objectives are achieved are often linked to the degree of independence of these Central Banks.

  Monetary Policy Fiscal Policy

Encouraging Demand

Increase Money Supply
Decrease Interest Rates

Decrease Taxes
Increase Government Spending

Discouraging Demand

Decrease Money Supply
Increase Interest Rates

Increase Taxes
Decrease Government Spending

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