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Economics 101

Fiscal Policy: What is it and How is it Relevant to Investors?

Since the times of the great depression in the 1930s, fiscal policy has been utilised as yet another tool to influence the level of economic activity within a given nation. However not without critical debate. Economists over time have argued both for and against the fiscal policy as a tool to influence economic activity. Those that are for it argue that government intervention into the economy is necessary, especially when a nation’s economy is within the downturn phase. Whilst the latter is of the view that government intervention is not necessary for stabilising economic activity, believing that through the ‘invisible hand’, the nation’s economy would adjust itself. Despite all this critical debate amongst economists, within Australia, fiscal policy is an integral component of our economy. 

The government’s Fiscal Policy is often considered the ‘sister strategy’ to Monetary Policy, through which a central bank aims to influence the economy. You can read more about Monetary Policy here.

What is Fiscal Policy?

Put rather simply, the fiscal policy relates to the levels of government revenue and spending within the economy. The vast majority of the government’s revenue is derived from taxpayers. However, the government may also receive revenue from other sources, such as state-owned enterprises. For example, the sale and subsequent privatisation of Medibank in 2014 would be classified as a form of government revenue. Likewise, the composition of government spending may vary from country to country, however, within Australia, welfare spending makes up a big component of the budget. For example, in the 2016 budget, the federal government expects over $158 billion in welfare spending.

Fiscal Policy as a Tool to Simulate the Economy

Fiscal policy can be used to influence the level of economic activity within a nation. It is often used as a tool to stimulate the economy in times of a downturn. For example, the Rudd government in 2009 announced an over $40 billion dollar ‘stimulus package’, in response to the onset of the global financial crisis, pitting the major economies of the world into the worst downturn since the great depression during the 1930s. Likewise, fiscal policy can be used to ease an economy, when rampant inflation is a problem. This may come in the form of restrictive policies such as increased income taxes to reduce consumption and increased company tax to reduce investment.

However, what happens when government expenditure is greater than its revenue? This is commonly known as a budget deficit. Since the GFC, the Australian federal government has been running consecutive budget deficits. Why is this the case? Often governments run deficits in order to stimulate the level of economic activity during times of a downturn. So, therefore, when a government is running a budget deficit, it has adopted what is known as ‘expansionary fiscal policy’. You may wonder where the government attains further funding in running a budget deficit. In funding a budget deficit, a government would usually issue more federal government bonds, where interested investors would purchase such bonds, and through a pre-determined interest rate, investors gain a return on the bond.

Although, when government revenue exceeds expenditure, it is known as a budget surplus. Between 1996-2007, the Howard government ran consecutive budget surpluses.

Setbacks of Fiscal Policy

Whilst fiscal policy can be a useful tool in influencing the level of economic activity within a nation, it does have its setbacks. These setbacks can be highlighted when a government is running a budget deficit.

As a budget deficit is funded by an increase in government borrowing, this increases the demand by the government for credit. Theoretically speaking, as a government increases its demand for credit to fund its deficit, there could be an increase in domestic interest rates. With the demand for credit being highly related to a finite money supply, domestic interest rates may increase. Therefore, the extent of the government’s expansionary policy stance may be hindered, due to the drop in output that comes with rising interest rates. 

This phenomenon is known as the ‘crowding-out effect’, and it can be countered by central banks increasing their efforts in decreasing domestic interest rates.

Relevance to Investors: Fiscal Policy in the Context of Financial Markets

Depending on the policy stance of the government, fiscal policy could affect the share market in a number of ways. For example, if the government were to adopt a policy stance that does not encourage growth in economic activity, then we may see declines in output, consumption, and investment. With not a very supportive economic environment for companies to grow in, investor sentiment may diminish, thus reducing share market returns. Likewise, if a government adopted a policy stance that greatly encouraged economic activity, then it may correspond with an increase in investor confidence within the share market, thus increasing its returns. Rising earnings translate into higher earnings per share, thus higher valuations – at least in theory. As we know. However, seeing as the share market is based on investor speculation, it’s quite difficult to tell which direction the market would go.

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Economics 101

Monetary Policy: What is Quantitative Easing and How is it Applied?

Since the onset of the GFC, a greater emphasis has been placed on central banks around the world to stimulate a recovering global economy. While we don’t want to place excessive emphasis on the actions of central banks, investors should be aware of their purpose and available tools to influence monetary policy.

We now live in an age where, as Mario Draghi, the President of the European Central Bank (“ECB”) famously put it, central banks are willing to do “whatever it takes” to stimulate the global economic environment. The success and measure of Central Banks are debatable and their actions have posed a series of questions: How can interest rates be at, or below zero? How can the central banks adopt such a stance to monetary policy?

One such strategy is commonly referred to as “quantitative easing”. In this piece, we will attempt to explain the unconventional economic phenomenon that is quantitative easing. 

Fundamentals of Monetary Policy

In order to understand quantitative easing, we must first understand the inner workings of monetary policy. Monetary policy is used by a nation’s central bank, where through their influence over the level of interest rates and the money supply (being the sole printers of a nation’s currency), they aim to create a stable financial environment. Most central banks believe that this can be achieved through economic growth, inflation and low unemployment.

Put simply, monetary policy is a tool utilized by a nation’s central bank, in order to achieve a set of economic goals. Like most central banks, the RBA (Reserve Bank of Australia) was born out of government legislation. In turn, it also acts as the government’s bank, where it takes on the role of conducting the government’s day-to-day transactions. Transactions that are necessary for the efficient operation of government.

As mentioned previously, one of the main roles of a central bank is to conduct monetary policy in order to achieve a stabilized level of output, inflation, and maximum employment. The central bank has limited tools available and aims to achieve these goals through for example influencing interest rates or money supply within a given economy.

‘Open Market Operations’ is a process, which involves the central bank playing an active role within the market, through the buying and selling of financial assets (for example Government Bonds) from financial institutions (such as Commercial Banks).

Open market operations enable the central bank to influence the availability of credit, through having an influence on the money supply in the economy. For example, if the central bank decides to lower the interest rates, they would increase their purchases of government bonds from financial institutions (such as Commercial Banks) to increase the money supply in the market. Hence, the series of transactions between the central bank and the financial institutions within the economy will have flow on effects, in the form of an increased money supply and a greater availability of credit. The opposite would apply if the central bank sought to increase interest rates to avoid hyperinflation or slow down expansion.

In Australia, the Reserve Bank of Australia (‘RBA’) is currently adopting an expansionary stance to monetary policy, recently cutting the cash rate to a record low of 1.75% in May.

What is Quantitative Easing?

Since the GFC, central banks around the world have been aggressively lowering interest rates in order to stimulate a dampening economic environment. The modern beliefs of today’s Central Banks is that the economy can be stimulated if money is “cheap” and therefore easily available. If consumers and businesses have to pay less to borrow more money, they will likely spend it on the economy, thus increase supply and demand. However, how can a central bank further stimulate an economy when interest rates are almost at zero? One critically debated strategy is called ‘Quantitative Easing’ (or QE). 

Quantitative Easing occurs when the Central Bank of a country purchases securities in order to increase the money supply. The Central Bank essentially “creates” or “prints” new money, which is used to buy financial assets from other commercial banks. The process involves a much more active policy in buying government bonds and other such assorted securities, from a vast range of financial institutions. The idea behind this process is that the banks have now more money available, which can be issued to borrowers such as consumers or businesses. As loans become more easily available, borrowers will lend more money and spend it, thus stimulate the economy.

QE is essentially just another form of OMO. However, the difference lies is the size and scale of the program. Rather than focusing just on short-term interest rates, QE also targets long-term rates. Furthermore, the central bank is concerned to influence the total amount of reserves, thus a significant expansion of their balance sheet is required.

Quantitative Easing around the World

Since the onset of the GFC, we have seen several instances of Quantitative Easing being implemented from central banks around the world. In the USA, we saw the US Federal Funds Rate drop to a record low of 0.25% in 2009. The Fed’s asset purchasing program quadrupled their balance sheet and injected an enormous amount of money in the economy.  Similarly in Europe, we currently see rates at zero. However, one of the most peculiar of cases is in Japan, where rates have gone negative at -0.10%.

Alternative Policies to QE

There have been scholarly discussions with regards to alternative policies to QE. The most prominent being the policy known as ‘Helicopter Money’. Proposed by well-known economist Milton Friedman, this involves the central banks applying an abnormal form of monetary stimulus, whereupon they directly transfer free funds into the private sector’s bank accounts. There are numerous critics who think that the actions of the central banks around the world have gone too far with their programmes, with further discussions of ‘Helicopter Money’ further exacerbating the criticism.

Whilst there are both benefits and disadvantages to such programmes, there is one thing for sure, and that is we are living in an abnormal age of the monetary policy, where central banks are pushing their roles to the limit beyond recognition and understanding.

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Economics 101

Why is the RBA Cutting Interest Rates?

The Board of the Reserve Bank of Australia (RBA) meets 11 times per year on the first Tuesday of each month to determine changes in the monetary policy for Australia. During the May 2016 meeting the RBA decided to lower the cash rate by 25 basis points to a record low of 1.75%. Back in September 1990, the cash rate was 14% before decreasing subsequently thereafter. The questions we are aiming to address in this research piece is: What is the cash rate, how does it affect me and why is the Australian central back ‘cutting’ the rates?

What is the Cash Rate?

The Reserve Bank of Australia defines the cash rate on its website:

“The interest rate which banks pay to borrow funds from other banks in the money market on an overnight basis.” – Source: The Reserve Bank of Australia.

In simple terms, the cash rate determines the cost to borrow money. If the cash rate is high, it becomes more expensive for banks or other financial institutions to borrow money, while a low cash rate makes lending cheaper.

The cash rate impacts the cost of funding for retail and investment banks and directly translates into interest rates. The cash rate has a powerful influence on other interest rates and forms the foundation on which the interest rates in the economy are built. A change in the cash rate has a knock-on effect on the interest rates on other financial products such as deposits, mortgages, personal loans, or foreign exchange products. While the banks’ overnight cost to borrow money does not affect the average Australian, so does the interest rate for deposits or mortgages. As explained, these rates are directly correlated.

As of May 2016, the cash rate is at a record low of 1.75%, but this has not always been the case. The graph below illustrates the historical cash rate in Australia since 1990.

Image: Historical cash rate in Australia. Source: RBA

We note several periods of rising as well as falling cash rates, however overall the direction since 1990 is down trending. The policy when the central bank increases the cash rate is called ‘financial tightening’, while the policy of lowering interest rates is called ‘loosening’ or ‘loose monetary policy’.

The Cash Rate as a Tool for Central Banks to Influence the Economy

The Reserve Bank of Australia is Australia’s central bank and conducts monetary policy, issues the nation’s currency and oversees the financial system of the country.

As per the RBA’s website, the Reserve Bank has three primary targets:

1. The stability of the currency of Australia;

2. The maintenance of full employment in Australia; and

3. The economic prosperity and welfare of the people of Australia

The RBA has to create and maintain a framework of policies to ensure stable financial conditions for Australia in order to achieve the abovementioned goals. In the financial world, none of these points is guaranteed and the central banks is somewhat limited in its powers.

The RBA uses the cash rate to influence the rate of inflation and economic growth in the country. The RBA uses a range of data points from both domestic and overseas markets to assess the health of the local economy and conclusively determine the most appropriate cash rate for the current economic conditions.

The cash rate is also an important financial benchmark in Australian financial markets as well as for the currency. The cash rate is often considered to be one of the primary drivers for the strength of the currency, as a higher than expected rate often has a bullish impact on the currency and vice-versa. However, the value of a currency unit is a relative value against the unit of another currency in the foreign exchange market, thus there are a range of factors that influence the strength.

Why is the RBA Cutting Rates in 2016?

During the past few years the Reserve Bank has consistently lowered the benchmark cash rate. The RBA believes that ‘easing monetary policy’, meaning lowering the cash rate, creates an accommodative environment for the local economy. The RBA believes that the lower cash rate translates into a lower currency, and thus supports demand which will eventually support inflation as well as economic growth.

The Impacts of Low Interest Rates on Australia

Falling interest rates affect everyday Australians in a number of ways. Generally, a drop in interest rates makes mortgage interest repayments more affordable and thus encourages Australians to lend money. On the other hand, a lower cash rate discourages saving as Australians earn less interest for money ‘sitting’ in the bank. Indirectly, the RBA aims to encourage spending which then translates into increased economic activity.

Alternative investment assets should technically benefit from low-interest rates as savers get less money in return for their cash. Therefore, low-interest rates encourage Australians to invest in assets that have historically generated higher rewards, such as equities.

In theory and as per ‘Economics 101’, lower interest rates mean higher stock market returns. However, history has taught us that this may not always be the case as a range of factors impact stock market valuations. Analysts often scrutinise the language that the RBA uses in their monetary policy statements to find any clues on future monetary policy. The overall economic conditions, stock market valuations as well as overseas events are just a few factors that impact stock prices, thus investors should not exclusively focus on central bank policies.

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Economics 101

Economic Indicators: Purchasing Managers Index (PMI)

The Purchasing Managers Index (PMI) is an index that measures manufacturing activity in an economy, based on surveys conducted on a specific set of purchasing managers on a monthly basis. The PMI is a leading indicator of economic health in a particular sector or the economy as a whole. The Purchasing Managers Index is used to measure manufacturing activity by many countries worldwide. The Australian Industry Group measures the Manufacturing PMI in Australia. 

Manufacturing PMI

The Australian Manufacturing PMI measures the manufacturing activity based on seven sub-indices and eight sub-sectors. Any reading above 50 indicates an expansion in manufacturing activity and any reading below 50 indicates contraction.

‘New orders’ is one of the most important sub-indices, and is generally considered a leading factor to changes in the economic output. A rise in new orders usually indicates an expansion in demand for the respective sector. The remaining sub-indices include Production, Sales, Exports, Deliveries, Stocks, and Employment.

Outlined below are the eight sectors that are gauthe Manufacturing PMI:

1. Food and Beverage: This sector measures the manufacturing activity amongst food, beverage and tobacco producers. This is the largest manufacturing sector in Australia and some of the external factors that may impact the output are currency movements, imports and exports.

2. Textiles, Clothing, Furniture and other: This is a relatively small sector and is mainly affected by retail demand.

3. Wood and Paper: The relatively small wood and paper products sector is affected by demand from the food and groceries sector and demand for wood products from the building industry.

4. Printing and Recorded Media: This sector is affected by technology change, import competition and fluctuations in currency. 

5. Petroleum, Coal and Chemicals: This sector covers manufacturers of pharmaceutical products, toiletries and health supplements and other construction materials such as paints and adhesives.

6. Non-Metallic Minerals: This sector gauges the demand for products such as tiles, bricks, cement, glass and other engineering construction and automotive supply chain parts. 

7. Metal Products: Gauging the change in demand for large metal products, this sector is affected by demand from the energy and resources sectors.

8. Machinery and Equipment: This sector measures the demand for automobiles and is generally affected by local currency fluctuations.

Purpose of PMI

Generally, the purchasing managers have early access to data about their company’s performance, which enables this index to be used as a leading indicator of overall economic performance. The PMI also allows economists to identify the ‘boom-bust’ business cycle, and assists analysts to see whether the demand and supply imbalances are readjusting within the sub-sectors and measure the effect on consequent changes in prices for each sector. The PMI is not revised after publication, unlike the other official data. Moreover, the PMI is produced using the same methodology across all countries, enabling accurate international comparisons.

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Economics 101

US Stock Market: How to Invest in the NYSE or NASDAQ

There are various stock exchanges in the USA, but the most known exchanges are arguably the New York Stock Exchange (“NYSE”) and the NASDAQ. These exchanges are two of the largest and most prestigious exchanges in the world. The NYSE regularly tops the list in rankings which are based on total market capitalisation or value of shares traded.

Similar to Australia, the overall performance of companies listed on these exchanges is often measured as a group to provide investors with a broad reflection over the overall stock market performance. Some of the most quoted benchmark indices are the S&P500, the Dow Jones Industrial Average (“DJIA”) or the Nasdaq 100. Many Australian investors read about the S&P500, the Dow Jones, Nasdaq or even the Russel 2000 on a daily basis in the business news of their local newspaper.

While all stock exchanges serve the common purpose of facilitating trading securities, they differ in nature. Even though investors purchase shares through their broker, it is important to understand the terminology and distinguish features or classifications of overseas markets. With a vast number of Australian brokers offering access to overseas stock exchanges, the purpose of this research note is to provide Australian investors with a brief overview of the US stock market and how you can invest in overseas equities. 

The New Stock Exchange – The Most Prestigious Stock Market

Established in 1792, the New York Stock Exchange is the oldest, largest and one of the most renowned stock exchanges in the world. This stock exchange has more than 3200 listed companies and is often referred to as the “Big Board”. As opposed to fully automated exchanges such as the ASX, the NYSE uses floor traders to facilitate transactions.  Until 1995, the exchange relied solely on the so called ‘open outcry’ system. The open outcry method is a system where dealers and brokers shout their bids and contracts aloud in order to execute a trade. While more than 50% of the trades are now performed electronically, customers can also send their orders to the floor through the public outcry system.

Some of the most known and largest companies are listed on the NYSE such as JP Morgan Chase and Co., Disney, Nike, General Electric, Johnson and Johnson, Alibaba Group Holdings or Walmart. 

The NASDAQ Stock Market

The NASDAQ Stock Market or often simply referred to as “NASDAQ” was founded in 1971 and is currently the second largest stock exchange in the US and the world, by market capitalisation (as at April 2016). Approximately 3100 companies are listed on the index and roughly 2 billion shares are traded on a daily basis. The NASDAQ is an electronic trading exchange and rather a communication system than a physical stock exchange. Orders are being executed by the online execution system or market makers.

Most US tech giants are listed on the Nasdaq such as Microsoft, Apple or Google and thus the technology sector makes up for nearly half of the industry breakdown. 
 
  

Three US Indices: S&P500, Dow Jones, and Russell 2000

Now let us have a brief look into the characteristics of three of the most commonly followed indices:

Standard and Poor’s 500

The Standard and Poor’s 500 indexes, often referred to as the ‘S&P 500’, is one of the most commonly followed equity indices in the USA, and is generally considered as one of the best representations of the US stock market and (to a certain degree) a bellwether of the country’s economy (read hear about the correlation of GDP growth and stock market returns). The S&P 500 index was launched on 4 March 1957 and currently consists of 500 companies with a total market capital of USD 7.8 trillion (as of April 2016).

The S&P 500 comprises of the 500 largest stocks, usually listed on the NYSE and Nasdaq Composite stock exchanges. These stocks are chosen based on specific criteria such as market capitalisation, liquidity, or their weighing on the industry. According to Standard and Poor’s, this index captures approximately 80% of the total market capitalisation of the US bourse.

Below is a table comprising of the largest companies by index weight (this data is as at 04/2016. No guarantee is made for the accuracy of this data).

CompanySymbolSector
Apple Inc.AAPLInformation Technology
Microsoft CorpMSFTInformation Technology
Exxon Mobil CorpXOMEnergy
Johnson & JohnsonJNJHealth Care
General Electric CoGEIndustrials
Facebook Inc (A Class)FBInformation Technology
Berkshire Hathaway (B Class)BRK.BFinancials
Wells Fargo & Co.WFCFinancials
Amazon.com IncAMZNConsumer Discretionary
Procter & GamblePGConsumer Staples

Dow Jones Industrial Average

The Down Jones Industrial Average is one of the oldest gauges in the world, often abbreviated as DJIA, and consists of the 30 largest companies listed in the US. Inclusion is based on a number of factors such as market capitalisation or volume. Along with the S&P 500 index, the DJIA is one of the most widely tracked indices in the world.

Russell 2000

The Russell 2000 is one of the most quoted benchmark indices for small capitalisation or “small-cap” stocks. This index comprises of the smallest 2000 companies listed on the U.S. stock exchanges such as the Nasdaq or the NYSE. 

What are the advantages of investing in US stocks?

Considering that US stocks have achieved outstanding returns over the long-term, it is often believed that Australian investors could benefit from “international diversification”. An increasing number of brokers offers easy access to international markets as there are a number of advantages for investing in the largest stock market in the world:

  1. Diversification: As we can see from the charts above, the industry breakdown of overseas markets may differ from the local market. Overseas markets can offer exposure to industries that are underrepresented on the ASX. In the US, companies from the information technology sector have a stronger weight on the overall market, currently around 20%. For example, this sector only has a 0.8% representation on the Australian Securities Exchange (as of April 2016) as investors are left with very few options to invest in IT.

  2. Access to the largest companies in the world: Some of the largest companies in the world are listed on the US stock exchange. To give you an idea of the extend, the market capitalisation of the largest stock on the S&P500, Apple Inc. (AAPL) is 8 times larger than the market cap of Commonwealth Bank of Australia (ASX: CBA). Many of the most known brands are listed in the US such as Disney, Nike, Amazon, or Google.

  3. Prestige & Regulation: The companies that are listed on the US exchanges are subject to the regulations of the US Securities and Exchange Commission (SEC). Furthermore, in order for a company to list on the NYSE or the Nasdaq, they are also required to comply with high listing requirements as it is required to comply with the distribution standards of the respective stock exchange. For example, A company’s share price must be above $4 in order to list on these stock exchanges.

What are the risks of investing in US stocks?

Investing in any type of security comes with a certain degree of risk and US stocks are no different. Click here to read our education article about the risks of investing in shares. The potential loss of capital is the greatest risk when it comes to investing, however, there are additional risks that need to be considered before investing in the US market (or overseas in general)

  1. Foreign exchange impact: Investing in overseas equities is subject to currency exchange fluctuations. As your holding is in the nominated foreign currency, the value in Australian Dollar (AUD) terms may fluctuate. Unfavourable foreign exchange movements can have a negative impact on one’s net value of a foreign investment. For example, if the AUD appreciates against the USD, the foreign investment that you are holding in USD would have declined in AUD terms (if you exchange it back into the local currency) and vice versa.

  2. Less understanding: While many investors may have a fairly good understanding of the Australian economy and Australian listed companies, they are often not able to fully comprehend overseas markets. The underlying fundamentals of US companies or the economy, in general, is quite different and often investors don’t understand overseas markets as much as their own domestic market. In addition, while these markets operate in different time zones, the price-sensitive announcements may be made while you are asleep which may limit your ability to take action.

  3. Tax Implications with Dividends: Australian residents often enjoy the benefits of franking credits for dividends distributed by ASX listed companies. There may be additional tax implications for overseas holdings that could impact net returns. For tax advice, we recommend you talk to a qualified financial planner or accountant.

How to invest in US Stocks?

Nowadays overseas stocks have become increasingly accessible for Australian investors. There are a number of domestic brokers that offer access to some of the largest stock markets in the world, such as the US market.

The first step is to check with your broker if they support trading in international shares. If an investor has an online share-trade account, they can often simply open an international trading account with their respective brokers online.

Find below a list of some of the most common brokers an investor can choose from here in Australia. (Please note that this list is not conclusive as there may be other providers available. Please consult with your financial planner firsty before opening an international share trading account. This list is for information purposes only, Wise-owl does not get any commissions from these links.)  

  • CommSec: Click here to access the website

  • Nabtrade: Click here to access the website

  • ANZ: Click here to access the website

  • Intelligent Financial Markets: Click here to access the website 

  • CMC Markets Stock Broking Limited: Click here to access the website

As soon as your application is approved and your account is funded, you can purchase international stocks, just as you would purchase Australian equities. Make sure you infrom yourself of trading hours, as order can only be executed while the market is open. If you have additional questions, feel free to call one of the advisors here at Wise-owl on 1300 306 308.

Investing in US Exchange Traded Funds (ETFs)

Put simply, an ETF (Exchange-Traded Fund) is a fully tradeable security that tracks the performance of a basket of securities, commodity or other financial instruments. ETF’s are usually issued by a bank or some other financial institution, which offer investors with diversified exposure to commodities, stock indices, currencies, and more.

For example, in the US, one of the most traded ETFs is the SPDR S&P 500 ETF, which tracks the movements of the S&P 500. Investing in ETF’s may increase diversification, as you are able to invest in a range of assets.

Often investing in ETFs is easier than picking individual stocks, hence Australian investors who want to invest in the US, could consider investing in an Exchange traded Fund.

Investors can choose from a variety of ETFs. Listed below are a few ETFs that offer Australian investors with exposure to the US stock market. (Please note that this list is not conclusive as there may be other providers available. This list is for information purposes only, Wise-owl does not get any commissions from these links.)

  • Blackrock: Click here to access the website 

  • ANZ: Click here to access the website 

  • Vanguard: Click here to access the website
     
  • State Street Global Advisors: Click here to access the website

  • BetaShares: Click here to access the website

  • Platinum Asset Management: Click here to access the website

Where do I find Research for US Companies?

The internet makes it possible to find information for any listed US company just as you would find commentary for Australian companies. Sources include the company website, newspapers, online editorials or stock forums. However, the challenge is to filter the advice you are getting. It is easy these days to get advice for everything, but it is not easy to get ‘good’ or ‘well researched’ advice.

Since 2015 Wise-owl offers stock tips for international equities as well. We focus on the largest companies in the U.S. and European stock markets with the primary focus on capital growth and dividends.

Members can click here to view our international portfolio and non-members can click here for a free trial in order to receive our international stock picks.

Please note that Wise-Owl does not receive any commissions from third party companies that are listed in this report.

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Economics 101

Economic Indicators: Inflation

Ever heard childhood stories from your parents or grandparents, talking about how they could visit the local Milk Bar and purchase a big bag of lollies for a couple of cents? I know I have heard it time and time again. While this is a very common story, it discusses a very interesting economic phenomenon that affects households and businesses every day. The few cents that could buy a bag of lollies during our grandparents’ generation, cannot purchase anything in today’s economy. The same bag of lollies will now have to be purchased at much higher prices. This phenomenon is called inflation.

What is Inflation?

Inflation refers to the sustained increase in the prices of goods and services from year to year, resulting in the decline in purchasing power of a country’s currency.

Some of the root causes of inflation could be:

  • Rapid increases in aggregate (overall) demand, higher than the increase in the supply of output. These are called demand-pull inflation pressures.
  • Increases in the costs of production or cost-push pressures, wherein higher production costs push the prices of goods sold. This includes one-off price shocks in certain commodities. Example: Australia witnessed a major price shock in the ’70s when OPEC curbed oil output, where the inflation rose to 20% a year. 

Excessive inflation can have varying effects on households and businesses such as a decrease in purchasing power, to what some economists would argue, an inefficiency in the money value system.

In the past 100 years, there have been severe cases of hyperinflation, meaning rapid increases in the prices of goods and services. One of the most prominent cases being in Zimbabwe, where at its peak in 2008, prices were doubling almost every 24 hours. Zimbabwe’s currency became so worthless, that in 2009, it was no longer in circulation. Instead, the country’s people opted to use a multitude of currencies, such as the South African Rand, USD, and the Euro.

Luckily, Australia hasn’t had such severe cases of inflation, where over the last 10 years, we have been able to achieve our target rate of 2-3% per annum.

How is Inflation Measured?

Although it may vary around the world, most countries use the CPI (Consumer Price Index), including Australia, as the main indicator of inflation levels. The CPI measures inflation by constructing a basket of around 100,000 goods and services that are weighted according to their importance to the metropolitan household.

Whilst the CPI does act as a relatively good indicator of inflation, it does have its limitations. As this ‘basket’ of goods and services is essentially fixed, it may over-exaggerate the increase in the price level, as it doesn’t account for the technological improvements in certain goods and services. For example, whilst smartphones are much more expensive than what mobile phones used to cost over 10 years ago, their functions go beyond just being a form of communication. Smartphones can be a gaming platform, business tool, or even simply an electronic encyclopedia, with their ease of access to search engines such as Google.

However, when analysing price changes, Central banks are not limited to simply one measure of inflation in the economy. Central Banks may also use the Core Inflation measurement, as an indicator of underlying price trends in the economy. Core inflation aims to take out the ‘one-off’ price shocks to the economy, which may either over-exaggerate or underwhelm price changes.

For example, when Cyclone Yasi hit Queensland in 2011, a lot of banana crops were destroyed, very noticeably decreasing the supply of banana’s, coinciding with a significant increase in prices to around $3 a banana. Whilst this price shock may hay have most likely coincided with slight increases in Headline Inflationary figures, there would be no change in Core Inflation, as it eliminates those ‘one-off’ price shocks that may lead economists and analysts astray.

Therefore, when measuring the levels of inflation in the economy, central banks, economists and analysts alike utilise several measurements of price changes in the economy, in order to fully understand the bigger picture.

Inflation’s Link with GDP

Inflation has an interchangeable link with the prime indicator of economic growth within a country, GDP (Gross Domestic Product). Within the ‘boom’ phase of the business cycle, where actual GDP is exceeding potential GDP, inflation is usually above the target rate. Likewise, during the ‘trough’, or recessionary stage of the business cycle, where actual GDP is below potential GDP, the inflation rate would usually be below the target rate. As was the case with the US economy during the GFC, wherein 2009, GDP growth and inflation were both negative.

GDP also acts as an indicator of society’s living standards (with many limitations). However, growth in inflation can also over-exaggerate GDP, and thus living standards. For example, Nominal GDP is the final value of all goods and services produced in an economy over a given period, at current market prices. If hypothetically in one year, inflation was quite above target, this would over-exaggerate the growth in Nominal GDP. However, this is not reflective of the society’s current living standards.

That’s why in analysing economic growth, analysts and economists alike prefer to use Real GDP, which provides a relatively accurate picture of a country’s economic growth after removing the effects of inflation.

Inflation’s Link with the Stock Market

The link between inflation and stock returns has often been discussed, with a multitude of results. In times of higher rates of inflation, corporate profits in some sectors may be lower, as inputs are higher, which in the short term, would further worry consumers. However, higher rates of inflation could possibly benefit some firms producing goods and services that have relatively inelastic demand, as consumers are not very reactive to price changes in certain goods and services.

Although, a study conducted on the US S&P 500 showed that, generally stock returns were higher when inflation is stable, with higher inflation coinciding with increased stock market volatility.

Can Inflation be Controlled?

Economists often argue and debate about whether inflation can be controlled, or should be left alone, in order to correct itself. However, since the GFC, central banks are making collective efforts in reaching their respective inflation goal.

This can be particularly seen through most developed economies’ central banks, such as the ECB (European Central Bank) and the BOJ (Bank of Japan), where they have adopted very accommodative monetary policy stances. Recently Japan succumbed to Negative Interest Rates, in order to avoid a rapid decrease in the prices of goods and services in an economy, otherwise known as deflation.

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Economics 101

Economic Indicators: Unemployment Data

Unemployment is one of the key economic indicators that describe the labour market conditions in a country. Most developed countries such as Australia use internationally agreed standards to define unemployment.

The Australian Bureau of Statistics releases the unemployment rate on a monthly and quarterly basis, reflecting the change in the number of people employed during that particular period.

Let us take a look into the main components of Australia’s unemployment data:

Who is an Unemployed Person?

According to the International Standard Classification of Occupations (ISCO), an unemployed person is one who is currently not engaged in a paid employment or self-employment, currently available to work, and is actively seeking employment opportunities. 

What is Unemployment Rate?

The unemployment rate is defined as the number of unemployed people, expressed as a percentage of the total labour force. Labour force is the total of employed and unemployed people in an economy.

What are the Types of Unemployment?

There are three main categories of unemployment: structural unemployment, frictional unemployment, and cyclical unemployment.

  • Structural Unemployment: A person is said to be structurally unemployed if he or she cannot find employment due to a mismatch between his or her skill set and the skills required by the company. Example: It is commonly seen that various companies require their employees to be adept with computer software skills, and if a person lacks the required software skills, he or she will not be offered the job.
  • Frictional Unemployment: A person is categorised to be frictionally unemployed, if he or she quits their current job, in order to find employment in another sector or another firm. It must be noted that a frictionally unemployed person does not lack in skills required for the job he or she is seeking to gain. However, in few cases, employers may have insufficient information about a potential candidate, resulting in them choosing another candidate for the job. Frictional unemployment lasts for a relatively short period of time, as the worker’s requirements are eventually met.
  •  Cyclical Unemployment:  This kind of unemployment is linked to the business cycle of an economy. People who are unemployed due to a recession in the economy, come under cyclical unemployment. These people generally find employment when the economy expands. Hence, in a growing economy, the number of people unemployed is lower. 

How does ABS Collect the Data?

The Australian Bureau of Statistics conducts monthly surveys to estimate the change in employment. It uses three sources to collect data:

  • Labour Force Survey: This is the official source of Australian employment statistics. The Labour Force survey uses a comprehensive set of questions to measure the number of people employed, unemployed, and those who are not economically active.
  • Census of Population and Housing and Special Social Surveys: While these methods are also used as indicators of current unemployment in the economy, these questionnaires don’t calculate the unemployment with the precision that the Labour Force Survey does.
  • ANZ Job Advertisement Series: The ANZ bank measures the number of jobs advertised in major daily newspapers and internet sites each month. This data can also be used as an indicator of labour market conditions.

What is Wage Growth?

Wage growth measures the change in the hourly wage of an employee after excluding monetary incentives such as bonuses.  This data is calculated on a quarterly and yearly basis. As of the August 2015 quarter, Australia’s wage growth was 2.3%, the lowest level in the past 15 years.

Importance of Unemployment Data

Unemployment data is often used as a measure to indicate the health of an economy, and its labour resources. It is usually witnessed that the unemployment rate in an expanding economy gradually decreases. However, the rate increases drastically if an economy enters recession. The unemployment data also acts as one of the factors to gauge the investor sentiment or consumer confidence levels in an economy. The investor sentiment is generally correlated to the number of jobs added in a particular period.

One must note that a low level of unemployment could also indicate a tight labour market with a possible scarcity of skilled labour. On the other hand, a high level of unemployment could also point towards sparse employment opportunities in an oversupplied labour market.

Criticism of Unemployment Data

While the ABS aims to publish data that reflects the ‘real’ unemployment as accurately as possible, the data is not flawless. Here are a few reasons why the official unemployment data is often criticised:

  • Those people who are not willing to seek employment are not included as a part of the labour force. The people are often referred to as ‘discouraged workers’, hence they are not included in the unemployment data. Based on this point, this means the ‘real’ unemployment rate is likely higher.
  • The unemployment data does not factor in ‘underemployment’, whereby workers who are currently working in a part-time job but are seeking a full-time occupation. It also does not account for those people who are overqualified for their jobs.
  • There are discrepancies due to illegal workers
  • As data is primarily derived from a survey, there may be slight variations between ‘official’ data and ‘real’ data.

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Economics 101

Economic Indicators: Gross Domestic Product (GDP)

GDP (Gross Domestic Product) is an economic indicator which records the level of goods and services produced within any given nation’s economy. It is one of the most important economic indicators for a country, as it assists in recording the level of output within their economy, along with, in part, acting as a benchmark for living standards.

GDP Further Explained

Broadly defined, GDP refers to the final market value of all goods and services within any given economy. GDP figures are usually released on a quarterly and yearly basis. Put simply, GDP aims to record the level of production within an economy.

Additionally, acting as an indicator for the level of economic wellbeing within a nation’s economy.

In measuring GDP, there are four components. These are:

Consumption (C): Consumption represents the value of all consumer spending within an economy. An example of C would involve the purchase of any Australian produced consumer item.

Investment (I): Investment expenditure represents the value of all the country’s investment spending. An example of this could involve an Australian business purchasing new capital equipment.

Government (G): Government expenditure refers to the value of the respective government’s spending, whilst not taking into account Welfare spending. An example of G could be the value of Government Infrastructure Spending.

Net Exports (NX): Net Exports relates to the overall value of a respective nation’s exports, whilst subtracting imports, which in isolation, acts as a burden on GDP. An example of NX would be the value of all Australian Iron Ore exports to China.

GDP Growth Rate

When measuring the improvement in a nation’s GDP, the GDP Growth Rate is often utilised. This involves comparing the current level of GDP to the preceding year, with the percentage difference being the growth rate.

Typically, Australia’s Goal of Sustainable Economic Growth is between 3-4%, not too high leading to inflationary pressures, nor not too low, leading to high unemployment and other recessionary factors.

GDP Per Capita

As briefly mentioned before, GDP can also act as an indicator for the level of living standards within a nation’s economy.

Through using the GDP Per Capita metric, it can act as a more understandable indicator of living standards. This involves dividing the overall level of GDP within any given nation, by the population of that nation. Through this, it helps to indicate the share of the ‘economic pie’ so to speak, within a nation.

For example, Australia’s GDP Per Capita in 2014 was $37,828.25.

Real vs Nominal GDP

There are several ways to measure GDP, with some being better indicators than others. Firstly, Nominal GDP records the final market value of all goods and services within an economy at constant rates, at current levels of inflation.

In contrast to Real GDP, which measures the final value of all goods and services within an economy, however, adjusted for inflation. This is done by basing the prices of those goods and services within the GDP figure, by a base year.

Real GDP is usually considered the better indicator of economic growth, through its particular focus on measuring production.

Whereas Nominal GDP may over-exaggerate the growth rate if there are consistently higher levels of inflation within an economy.

Is GDP a Suitable Indicator for Prosperity of a Country?

Whilst GDP acts as the main indicator of economic growth and is often used to describe prosperity within an economy, critics say the metric isn’t perfect.

As an example, one of the criticisms is that it doesn’t take into account the value of the ‘Cash Economy’.

Moreover, another critique of GDP as a measure of economic wellbeing, is that it doesn’t account for ‘non-material’ aspects. Example’s being the crime rate, access to food and education, along with pollution associated with production.

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Economics 101

Economic Indicators: Balance of Payments (BOP)

The Balance of Payments is an economic indicator and the overall record of all economic transactions of a country. It is an important macro-economic indicator that helps a country’s Reserve Bank to gauge the economic trends in the past, and create monetary policies. The Balance of Payment indicator constitutes of the following three sub-indicators:

– Current Account
– Capital Account
– Financial Account

Balance of Payments Explained

The Balance of Payments (BOP) records the monetary value of transactions that have occurred between the residents of one country and residents of other countries in a particular period. This is generally reported on a quarterly and yearly basis. The BOP includes all transactions that have taken place in the private and public sectors. Simply put, the money flowing into the economy has a positive impact (credit), while the money flowing out of the economy has a negative impact (debit) on the total Balance of Payments.

BOP is divided into three accounts: Current Account, Capital Account and Financial Account.

Current Account:
 The current account records the money spent and received on goods and services. Balance of Trade forms the major portion of the Current Account, but it also includes Receipts from income-generating assets, such as dividends received on equities and interest on other investments, as well as Cash Transfers made internationally. 

Balance of Trade (BOT):
 Balance of Trade refers to the difference between a country’s exports and imports and makes up the main portion of the Current Account indicator.

While calculating the BOT, a country’s imports, expenditure on foreign aid, investments, and spendings in other countries are debited and the amount of money received from the export of goods and services, foreign direct investments made in the domestic economy are credited.

If a country’s total exports are greater than the total imports, it has a trade surplus (positive balance). However, if a country’s total exports are lower than its total imports, the country has a trade deficit (negative balance). Countries like Germany and China have a trade surplus, while nations like the US, India, and Australia have a trade deficit.

Having a trade deficit is not necessarily a drawback, however, it is relative to the business cycle of the economy. When a country is going through an expansionary stage, the reserve bank of the nation will aim for a trade deficit. Higher imports encourage international competition, which keeps the domestic prices from inflating. When a country is experiencing deflation, it will aim for a trade surplus, in order to boost its exports, create more jobs and increase demand for its goods.

Capital Account:
 The capital account reflects the net change in asset ownership for a country. This account records the purchase and sale of non-financial and non-produced assets, which are required for production.

This indicator also interprets the monetary value of transactions such as the transfer of financial assets by residents who are migrating the country, the purchase and sale of foreign assets by a domestic company, and the purchase and sale of domestic assets by a foreign company.

Financial Account: This component covers claims in regards to financial assets, such as gold, currency, derivatives, special drawing rights, shares, and bonds.

Balance of Payments Should Theoretically Equal Zero

Theoretically, a country’s balance of payments should be zero. The total of the current account should be equal to the sum of the capital account. A deficit in the current account is balanced out by a surplus in the capital account.

For example, if a country is going through an expansionary stage, large foreign corporations are attracted to enter the market through investments. This scenario has a balancing effect: While the foreign direct investment will increase the capital account balance, it will also increase competition among local businesses, and ultimately make the products and services cheaper. The low prices will have a negative impact on the country’s current account. Hence the net effect is zero.