Economic Factors & Business Information

Economic Indicators

Economic indicators are statistical data points that provide insight into the overall health and direction of an economy. Investment adviser representatives must understand these indicators because they drive investment decisions, portfolio construction, and client communication. Economists categorize indicators by their timing relationship to the broader economy: leading indicators change before the economy shifts direction, coincident indicators move simultaneously with the economy, and lagging indicators confirm trends that have already begun.

The Conference Board publishes composite indexes of leading, coincident, and lagging indicators. These composites aggregate multiple individual data points to provide a more reliable signal than any single indicator alone. Understanding which category each indicator falls into is essential for the Series 65 exam and for practical advisory work.

Leading Economic Indicators

Leading indicators are forward-looking metrics that tend to change direction before the overall economy does. They are valuable for predicting future economic conditions and are closely watched by policymakers, economists, and investment professionals. The Conference Board's Leading Economic Index (LEI) includes ten components:

• Building permits for new private housing: Construction requires significant capital commitment and signals confidence in future economic conditions. A decline in building permits often precedes economic slowdowns as developers anticipate reduced demand.
• Stock prices (S&P 500): Equity markets are forward-looking by nature. Stock prices reflect collective expectations about future corporate earnings and economic conditions. A sustained decline in stock prices often foreshadows an economic downturn.
• Money supply (M2): The real money supply adjusted for inflation indicates the amount of liquidity in the economy. An expanding money supply supports economic growth by making credit more available for business investment and consumer spending.
• Initial claims for unemployment insurance: When initial jobless claims rise, it signals that employers are laying off workers, which typically precedes broader economic weakness. Conversely, declining claims suggest labor market strength ahead.
• Manufacturers' new orders (consumer goods): New orders represent future production activity. Rising orders indicate that businesses expect increased demand, while falling orders suggest an anticipated slowdown.
• Average weekly hours (manufacturing): Employers tend to adjust hours before adjusting headcount. An increase in average weekly hours suggests firms are ramping up production, while a decrease may precede layoffs.
• Interest rate spread (10-year Treasury minus federal funds rate): A wider spread indicates expectations of future economic growth, while a narrow or inverted spread (negative) has historically preceded recessions.
• Consumer expectations (University of Michigan survey): Consumer sentiment about future economic conditions influences spending decisions. Rising expectations support economic expansion.
• Manufacturers' new orders (nondefense capital goods): These orders reflect business investment in equipment and technology, signaling confidence in future productivity and growth.
• Leading Credit Index: This measures credit conditions including lending standards, which tighten before economic downturns and loosen during recoveries.

Coincident Economic Indicators

Coincident indicators move in tandem with the overall economy and reflect current economic conditions. They confirm what is happening in the economy right now rather than predicting future trends. The four key coincident indicators are:

• Gross Domestic Product (GDP): The total market value of all final goods and services produced within a country's borders during a given period. GDP is the broadest measure of economic activity. Real GDP adjusts for inflation, providing a more accurate picture of growth. Two consecutive quarters of negative real GDP growth is the informal definition of a recession.
• Industrial production: Measures the output of factories, mines, and utilities. It reflects the current level of manufacturing activity and correlates strongly with economic expansions and contractions.
• Personal income (less transfer payments): Wages, salaries, and other earned income (excluding government transfers like Social Security or unemployment benefits). Rising personal income supports consumer spending, the largest component of GDP.
• Manufacturing and trade sales: The total dollar value of sales at the manufacturing, wholesale, and retail levels. This reflects current demand for goods across the supply chain.

Lagging Economic Indicators

Lagging indicators change direction after the economy has already begun to follow a particular trend. They confirm that a trend is underway and are useful for verifying that an economic shift has occurred. Key lagging indicators include:

• Consumer Price Index (CPI) for services: Inflation tends to accelerate after the economy has been expanding for some time and to decelerate after a contraction is underway.
• Average duration of unemployment: This rises well after a recession has begun and falls well after a recovery is underway, as employers are slow to rehire after downturns.
• Bank prime rate: Commercial lending rates adjust after economic conditions have already changed, responding to Federal Reserve actions that themselves follow economic data.
• Commercial and industrial loans outstanding: Business borrowing patterns change slowly in response to economic conditions that have already shifted.
• Ratio of consumer credit to personal income: Consumers adjust their borrowing patterns after economic conditions have changed, with credit-to-income ratios rising during prolonged expansions.
• Inventories-to-sales ratio: Businesses adjust inventory levels after observing changes in sales patterns, making this a trailing measure of economic activity.
• Change in labor cost per unit of output: Unit labor costs adjust as productivity and wages change in response to economic conditions that have already shifted.

The Business Cycle

The business cycle describes the recurring pattern of expansion and contraction in economic activity over time. While no two business cycles are identical in length or intensity, they follow a predictable sequence of phases. Investment adviser representatives must understand business cycle dynamics to make appropriate asset allocation recommendations and to help clients set realistic expectations during different economic environments.

Expansion Phase

During an expansion, economic activity accelerates. GDP grows, corporate earnings rise, employment increases, consumer confidence improves, and business investment expands. Interest rates may start low (near the trough) and gradually increase as the economy gains momentum and the Federal Reserve begins tightening monetary policy to prevent overheating. Stock prices generally rise during expansions as investors anticipate higher corporate profits. This is the longest phase of a typical business cycle, often lasting several years.

As the expansion matures, capacity utilization increases, labor markets tighten, and inflationary pressures begin to build. Wages rise as employers compete for a shrinking pool of available workers, and input costs increase as demand for raw materials grows. The Federal Reserve responds by gradually raising interest rates to cool the economy and prevent inflation from spiraling.

Peak Phase

The peak represents the highest point of economic activity before a downturn begins. At the peak, GDP growth reaches its maximum rate, unemployment is at its lowest, and capacity utilization is highest. However, the peak also brings maximum inflationary pressure. Interest rates tend to be at their highest point in the cycle as the Fed has been tightening to combat inflation. Corporate profit margins may begin to compress as input costs rise faster than companies can raise prices.

It is important to understand that the peak is only identified in retrospect. While the economy is at its peak, most participants believe growth will continue. The National Bureau of Economic Research (NBER) is the official body that declares business cycle turning points, and these announcements typically come months after the fact.

Contraction Phase (Recession)

A contraction is a period of declining economic activity. GDP falls, corporate earnings decrease, unemployment rises, and consumer confidence deteriorates. The formal definition of a recession is typically two consecutive quarters of negative real GDP growth, though the NBER considers a broader range of factors. During contractions, the Federal Reserve typically cuts interest rates to stimulate borrowing and investment. Stock prices generally decline, particularly for cyclical sectors, while defensive sectors and high-quality bonds tend to outperform.

Contractions vary significantly in severity. A mild recession may involve only a modest decline in GDP and a temporary rise in unemployment, while a severe recession (like 2007-2009) can involve deep GDP declines, massive job losses, financial system stress, and prolonged recovery periods. The term "depression" is reserved for the most severe and prolonged downturns, though there is no universally agreed-upon quantitative definition.

Trough Phase

The trough is the lowest point of the business cycle, marking the transition from contraction to expansion. At the trough, GDP has fallen to its lowest level, unemployment is at or near its highest, and consumer and business confidence is at its weakest. However, leading indicators begin to turn positive, signaling that recovery is ahead. Interest rates are typically at their lowest as the Fed has been aggressively easing. From the trough, the economy begins a new expansion, and the cycle repeats.

Monetary Policy

Monetary policy refers to the actions taken by the Federal Reserve (the central bank of the United States) to influence the availability and cost of money and credit in the economy. The Fed's dual mandate, established by Congress, directs it to promote maximum employment and stable prices (low inflation). Understanding monetary policy is critical for investment advisers because Fed actions directly impact interest rates, asset prices, and economic conditions that affect client portfolios.

The Federal Reserve System

The Federal Reserve System was established by the Federal Reserve Act of 1913. It consists of the Board of Governors (seven members appointed by the President for staggered 14-year terms), twelve regional Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The FOMC is the primary monetary policy-making body and consists of the seven Board members plus five of the twelve Reserve Bank presidents (the New York Fed president is a permanent member; the other four rotate annually). The FOMC meets approximately eight times per year to evaluate economic conditions and set the direction of monetary policy.

Fed Tools: Traditional Monetary Policy

The Federal Reserve has several tools at its disposal to implement monetary policy:

1. Open Market Operations (OMO): The buying and selling of U.S. government securities (primarily Treasury bonds) in the open market. This is the Fed's most frequently used and most flexible tool. When the Fed buys securities, it pays for them by crediting the reserve accounts of the selling banks, injecting new money into the banking system (expansionary). When the Fed sells securities, banks pay from their reserves, draining money from the system (contractionary). The Federal Reserve Bank of New York conducts these operations on behalf of the FOMC.
2. The Discount Rate: The interest rate the Fed charges commercial banks for short-term borrowing at the "discount window." Lowering the discount rate reduces the cost of borrowing, encouraging banks to lend more (expansionary). Raising the discount rate increases borrowing costs and discourages lending (contractionary). Banks typically borrow at the discount window only as a last resort.
3. Reserve Requirements: The percentage of customer deposits that banks must hold in reserve rather than lending out. Lowering the reserve requirement frees up more funds for lending (expansionary). Raising it restricts the amount banks can lend (contractionary). As of March 2020, the Fed reduced reserve requirements to zero percent, but this concept remains testable on the Series 65.
4. Federal Funds Rate Target: The FOMC sets a target range for the federal funds rate, which is the rate at which banks lend reserves to each other overnight. This is the most closely watched interest rate in the world. The Fed influences this rate through open market operations rather than setting it directly. Changes in the fed funds rate ripple through the entire economy, affecting mortgage rates, credit card rates, business loans, and bond yields.

Expansionary vs. Contractionary Policy

The Fed's policy stance is characterized as either expansionary (loose/accommodative) or contractionary (tight/restrictive) depending on the economic conditions it is trying to address:

Quantitative Easing (QE)

When traditional monetary policy tools prove insufficient, particularly when interest rates are already near zero (the "zero lower bound"), the Fed may resort to unconventional measures. Quantitative easing (QE) involves the Fed purchasing large quantities of longer-term securities, including Treasury bonds and mortgage-backed securities, to inject money into the financial system, push down long-term interest rates, and encourage lending and investment.

The Fed employed QE extensively during and after the 2008 financial crisis (QE1, QE2, and QE3) and again during the COVID-19 pandemic in 2020. QE differs from standard open market operations in its scale and the types of securities purchased. While standard OMO typically involves short-term Treasury bills, QE targets longer-duration securities to directly reduce long-term borrowing costs. The opposite process, where the Fed reduces its balance sheet by allowing securities to mature without reinvesting, is called quantitative tightening (QT).

Fiscal Policy

While monetary policy is conducted by the Federal Reserve, fiscal policy is determined by the federal government through Congress and the President. Fiscal policy involves government spending and taxation decisions designed to influence economic conditions. Investment advisers need to understand fiscal policy because government spending priorities, tax laws, and deficit levels have significant implications for investment returns, sector performance, and client tax planning.

Government Spending

Government spending is a direct component of GDP. When the government increases spending on infrastructure, defense, healthcare, or other programs, it directly adds to economic output and creates jobs. This is expansionary fiscal policy. The Keynesian economic theory, developed by John Maynard Keynes during the Great Depression, argues that during severe economic downturns, increased government spending can compensate for reduced private sector spending and help restore economic growth.

The multiplier effect amplifies the impact of government spending. When the government spends $1 billion on infrastructure, the workers and suppliers who receive that money spend a portion of it, which becomes income for others, who spend a portion of that, and so on. The total economic impact is a multiple of the original spending, with the exact multiplier depending on the marginal propensity to consume.

Taxation

Tax policy is the other lever of fiscal policy. Reducing taxes leaves more money in the hands of consumers and businesses, encouraging spending and investment (expansionary). Raising taxes reduces disposable income and corporate profits, dampening economic activity (contractionary). Different types of tax changes have different economic effects:

• Income tax cuts: Increase disposable income for consumers, boosting consumer spending (the largest component of GDP).
• Corporate tax cuts: Increase after-tax profits, encouraging business investment, stock buybacks, and dividend payments. May boost stock prices.
• Capital gains tax changes: Higher capital gains rates may discourage selling and reduce market liquidity. Lower rates may encourage realization of gains and investment.
• Payroll tax changes: Directly affect take-home pay for workers and employment costs for businesses.

Budget Deficit vs. Surplus

When government spending exceeds tax revenue in a given year, the result is a budget deficit. The government finances deficits by issuing Treasury securities (borrowing). Persistent deficits lead to a growing national debt. A budget surplus occurs when revenue exceeds spending. Deficits tend to be expansionary (more money flows into the economy than is taken out through taxes), while surpluses are contractionary.

Large deficits can lead to crowding out, where government borrowing competes with private sector borrowing for available capital, potentially pushing up interest rates and reducing private investment. This is a concern particularly during periods when the economy is already operating near capacity.

Interest Rates and the Fisher Equation

Interest rates are the price of borrowing money and one of the most important variables in all of finance. They affect bond prices, stock valuations, real estate values, consumer spending, and business investment. Investment adviser representatives must understand the relationship between different types of interest rates and how they are determined.

Nominal vs. Real Interest Rates

The nominal interest rate is the stated or observed rate on a loan or investment. It is the rate you see quoted on bank deposits, bonds, and mortgages. However, the nominal rate does not account for inflation. The real interest rate adjusts the nominal rate for inflation and represents the true increase in purchasing power earned by an investor or the true cost of borrowing.

The relationship between these rates is described by the Fisher equation, named after economist Irving Fisher:

Real Interest Rate = Nominal Interest Rate − Inflation Rate

For example, if a bond pays a nominal yield of 6% and inflation is running at 2%, the real return is approximately 4%. This means the investor's purchasing power is growing by 4% per year. If inflation rises to 7%, the real return becomes negative (-1%), meaning the investor is actually losing purchasing power despite earning nominal interest.

Factors Affecting Interest Rates

Multiple factors influence the level and direction of interest rates:

• Federal Reserve monetary policy: The most direct influence on short-term rates. The FOMC's target for the federal funds rate anchors all short-term borrowing costs.
• Inflation expectations: When investors expect higher future inflation, they demand higher nominal yields to compensate, pushing rates up. This is why inflation expectations are a key component of long-term bond yields.
• Government borrowing (fiscal policy): Large budget deficits increase the supply of government bonds, which can push yields higher. This is the crowding-out effect.
• Economic growth expectations: Strong growth increases demand for credit, pushing rates up. Weak growth reduces credit demand and pushes rates down.
• Foreign capital flows: Strong demand from foreign investors for U.S. Treasury securities can push yields down, while reduced foreign demand can push yields higher.
• Risk appetite: During periods of market stress, investors flee to the safety of government bonds, pushing Treasury yields down (the "flight to quality").

Inflation and Deflation

Inflation is a sustained increase in the general price level of goods and services, resulting in a decline in the purchasing power of money. Moderate inflation (typically around 2%, which is the Fed's target) is considered normal and healthy for a growing economy. However, high inflation can erode savings, distort investment decisions, and create economic instability. Deflation, a sustained decrease in the general price level, is equally problematic because it can lead to a deflationary spiral of reduced spending, lower corporate revenues, job losses, and further price declines.

Types of Inflation

• Demand-pull inflation: Occurs when aggregate demand exceeds aggregate supply. "Too much money chasing too few goods." This type is common during periods of rapid economic expansion when consumer and government spending outpaces the economy's productive capacity.
• Cost-push inflation: Occurs when rising production costs (wages, raw materials, energy) push up prices. Supply shocks, such as oil price spikes, are classic examples. Cost-push inflation can occur even during periods of weak economic growth, leading to stagflation.
• Monetary inflation: Occurs when the money supply grows faster than the economy's productive capacity, diluting the value of each dollar. This is consistent with the monetarist view championed by Milton Friedman: "Inflation is always and everywhere a monetary phenomenon."

Measuring Inflation

• Consumer Price Index (CPI): The most widely cited inflation measure, tracking price changes for a basket of consumer goods and services including food, housing, transportation, and medical care. Published monthly by the Bureau of Labor Statistics.
• Producer Price Index (PPI): Measures price changes at the wholesale level. Because producer costs eventually get passed on to consumers, PPI can serve as a leading indicator of CPI.
• GDP Deflator: The broadest measure of inflation, covering all goods and services produced in the economy (not just consumer goods). Used to convert nominal GDP to real GDP.
• Personal Consumption Expenditures (PCE) Price Index: The Fed's preferred inflation measure. It differs from CPI in its weighting methodology and broader scope, and tends to show slightly lower inflation than CPI.

Investment Implications of Inflation

Inflation affects different asset classes differently. Fixed-income investments (bonds) are hurt by unexpected inflation because the fixed coupon payments lose purchasing power, and rising rates cause bond prices to fall. Equities can provide some inflation protection because companies can often raise prices, but high inflation compresses profit margins and increases uncertainty. Real assets (real estate, commodities, TIPS) tend to benefit from inflation. Cash and money market funds lose purchasing power during high inflation but benefit from rising short-term rates.

Balance of Payments & Exchange Rates

In an increasingly interconnected global economy, international economic factors significantly influence domestic financial markets and investment returns. Investment adviser representatives must understand how cross-border trade, capital flows, and currency movements affect client portfolios.

Balance of Payments

The balance of payments (BOP) is a comprehensive record of all economic transactions between residents of a country and the rest of the world during a given period. It has two main components:

• Current Account: Records the flow of goods, services, income, and unilateral transfers. The trade balance (exports minus imports of goods and services) is the largest component. A current account deficit means a country imports more than it exports, while a surplus means the opposite. The United States has run persistent current account deficits for decades.
• Capital (Financial) Account: Records the flow of financial assets between countries, including foreign direct investment, portfolio investment (stocks and bonds), and central bank reserve transactions. A current account deficit must be offset by a capital account surplus (foreign investment flowing into the country) for the BOP to balance.

Exchange Rates

An exchange rate is the price of one currency expressed in terms of another. Exchange rates affect the returns of international investments, the competitiveness of domestic exporters, and the prices of imported goods.

Under a floating exchange rate system (used by most developed economies), currency values are determined by supply and demand in foreign exchange markets. Key factors influencing exchange rates include:

• Interest rate differentials: Higher interest rates attract foreign capital seeking higher returns, increasing demand for the currency and pushing its value up. This is a key reason why currency movements often track central bank policy decisions.
• Inflation differentials: Countries with higher inflation tend to see their currencies depreciate because their goods become less competitive internationally (purchasing power parity theory).
• Trade balances: Countries with trade surpluses experience increased demand for their currency from foreign buyers, supporting its value. Trade deficit countries experience the opposite.
• Economic growth: Strong economic growth attracts foreign investment, supporting the currency.
• Political stability: Political uncertainty can cause capital flight, weakening the currency.

Impact on Investment Decisions

A strong dollar (appreciating U.S. currency) makes U.S. exports more expensive abroad, potentially hurting profits of multinational U.S. companies. However, it makes foreign goods cheaper for U.S. consumers and reduces the dollar-denominated returns of foreign investments held by U.S. investors. A weak dollar has the opposite effects: it helps U.S. exporters, makes foreign goods more expensive, and boosts the dollar returns of foreign investments.

Investment advisers should consider currency exposure when constructing portfolios with international allocations. Some international funds hedge currency risk, while others leave it unhedged, and the choice can significantly affect returns depending on currency movements.