What is the economy?
The economy is the influence of our choices – individuals, companies and governments – on activities related to production and consumption of goods and services. It is dictated by the Law of Supply and Demand. It is this very principle that determines the price you will pay for a product or service.
Demand is the quantity of a product or service that consumers are willing to purchase at a given price. Supply is the quantity of a product or service that companies are willing to produce at a given price. With that in mind, the law of supply and demand typically leads to the following.
When prices go up:
- Supply tends to increase for several reasons: either producers have an advantage to offer a greater amount of the goods as they will receive more for it; either new producers are motivated to enter the market and produce this high-yielding product; or the people who own this product are motivated to sell it.
- Demand tends to dwindle because the higher the price of a product, the less inclined consumers are to purchase it.
When prices go down:
- Supply tends to go down as producers don’t see as many incentives to market this product if they get less in return.
- Demand tends to rise since consumers are more willing to purchase this product at a lower price.
The law of supply and demand is constantly trying to find that perfect balance (known as the equilibrium) where prices are directly proportioned to both the demand and the effort that producers must make to produce a given product.
The following graph illustrates this principle:
Inflation is another very important variable in the understanding the economy. It represents the loss of purchasing power of a currency over time. For instance, with $1,500 in 1950, you could buy a car; today, you would need approximately $30,000. This change is caused by a general increase in the cost of living and, as such, in the value of goods and services.
When you are investing for the long term, as is often the case for retirement, it is crucial to account for inflation and supply and demand movements in financial markets, in order to ensure that your assets grow at a higher pace than the increase in the cost of living.
Economic growth refers to the capacity of an economy to produce goods and services over time. We use economic growth data to evaluate a country’s financial health.
Products and services go through several production stages before being offered to us. The gross domestic product (GDP) factors in the quantity of final products manufactured over a certain period. Economic growth corresponds to the percentage of variation in GDP.
Generally, the rule states that a country is in recession when its GDP is negative at least two consecutive quarters during the year.
The main factors influencing economic growth include:
- Population growth. As the number of workers increases, production follows suit.
- National capital growth. Education, training and the use of increasingly sophisticated tools boost the level of production per worker.
- Technological developments. Technological advances help optimize the use of real estate, financial and human resources.
In the investment world, it is important to consider the economic growth rate of a country, especially when investing a great deal of your assets within a specific sector (for instance, in natural resources).
The economic cycle
An economic cycle contains five main stages evolving at different paces.
When managing your investments, it is important to consider the current economic cycle. A good rule of thumb is to invest during an economic trough, due to the imminent recovery; while investing during a peak can result in a near-by contraction, i.e., potential losses.
You need to be very careful when attempting to time the ideal moment to invest because these stages are irregular and highly unpredictable. It is best to invest in products that suit your profile and that you can hold over a long period. By doing so, you can take advantage of opportunities in times of recovery.
Economic indicators serve to analyze a country’s economic situation in order to determine in which stage of the economic cycle it is.
There are three categories of economic indicators:
- Leading indicators – They help predict a peak or trough. They are the most useful and most used because they help predict changes by confirming what companies and consumers have already started producing and spending.
- Coincident indicators – They vary more or less at the same time as the economy, and inform us of its current state. For instance, GDP, retail sales, personal income.
- Lagging indicators – They change after the economy and therefore serve to confirm an economic change. For instance, inflation and unemployment rates.
Economic indicators can influence investors because they evaluate the current and future state of the economy. As a result, they help determine if certain products are (will be) profitable within that context, based on their level of correlation to economic variations.
Interest rates are a determining factor between the current and future state of the economy. For consumers, interest rates refer to the benefits or disadvantages (gains or losses) of postponing their purchases. For companies, these rates represent the cost of borrowing.
Interest rates are one of the most important financial variables in the world of investing. Any change in that regard affects both demand and supply, and has a direct impact on bonds and money markets.
As an investor, it is just as important to know the current rate of interest as the direction it is about to take. Knowing this allows you to better evaluate the profitability of an investment made today (if interest rates are low) or postponed for a few months (if interest rates are anticipated to go up).