分类： Worldwide Economics

How Can Stock Markets Impact US Presidential Elections?

• How can returns in the Dow Jones , S&P 500 influence voters at the polls?
• This study analyzes the indices 1 year and 3 months before elections
• Do voters respond to stock performance as an election nears?

Introduction

Many factors can impact the outcome of US presidential elections, such as the shape of the economy, a voter’s background, turnout, outcomes in swing states and more. But what about returns in the stock market?

This is a special report that will analyze the performance of the S&P 500 and Dow Jones leading up to the 22 presidential elections since 1932. I will examine how the two indices performed on average one year and 3 months before an election, comparing their returns against whether or not the incumbent party won.

Background

First, let us consider how might the performance in stocks influence elections in the first place? The price of a stock represents ownership of a fraction of a corporation, and is influenced by supply and demand forces reflecting the given firm’s expected fortunes. Some stocks will pay you a dividend and grant you voting access in shareholder meetings. But most importantly, you gain the right to sell the stock in the future.

If the price of a stock rises in value, the holder can make a profit by selling at a higher price than where they entered. If investors think that a business can make more returns in the future, boosting demand for their shares, then the price will often rise. There can be both specific and systematic forces that determine which way a stock can go. This piece focuses on the latter, or how the shape of the US economy as a whole drives stocks.

The S&P 500 and Dow Jones are stock indices that weight key sectors in the economy differently, such as information technology, real estate and energy. If their returns are positive heading into an election, this could be because investors expect the underlying businesses to generate more profits in the future. This could be due to a rosy outlook for economic growth , perhaps raising the odds of the incumbent party maintaining its grip on power.

Conversely, if stock returns are negative heading into an election, it could be due to a more pessimistic outlook for growth . If this is the case, then one might reasonably assume that the party running for reelection could be at a higher risk of losing its position. That is only the case, of course, if voters generally value the performance of stock markets. This is a limitation in this study, discussed in further detail at the end.

S&P 500, Dow Jones Returns 1 Year Before Presidential Election

Of the 22 elections since 1932, there were 18 instances when returns in the S&P 500 and Dow Jones one year before a presidential election averaged positive. Of those 18 occurrences, the incumbent party won 11 times, or about 61.11%. Returns in the stock market were negative the other 4 times. Of those, the incumbent party lost 3 times, or about 75% – see table below.

S&P 500, Dow Jones Returns 3 Months Before Presidential Election

What happens in this study when the time frame changes from 1 year to 3 months before an election? In this case, of the 22 occurrences, there were 13 when stock returns were positive. Of those instances, 11 times, or 84.62%, the incumbent party won. Meanwhile, there were 8 instances when stock returns were negative. The incumbent party lost 7 times in this case, for about an 88.89% failure rate.

Conclusion

In short, the 3-month data seems to offer more consistent outcomes compared to 1-year out. More often than not, the performance of the stock market closer towards an election seems to correlate with whether or not an incumbent party wins. It should be noted that correlation does not imply causation. It could be that voters place greater emphasis on stocks 3 months before an election as they pay more attention to current events in preparation for casting ballots. There are some limitations to this study.

 

What is Employment?

Employment is considered to be a key economic driver and is an important measure of economic growth . According to the International Labor Organization, unemployment is defined as ‘’people of working age who are without work, available for work and actively seeking employment.” So, thereby, those that have jobs are considered employed while those that do not have a job but are currently looking for one are considered unemployed. Although the unemployment rate is not infallible, it is an important factor to consider when performing fundamental analysis and can be likened to the basic economic principle of supply and demand.

Because the change in supply/demand of labor has a direct impact on both growth and consumer spending; unemployment, gross domestic product (GDP) and Inflation are often perceived to be inter-related and all form part of the primary macroeconomic objectives set out by policymakers. Data releases with employment statistics are some of the most important events on the economic calendar and are followed closely by both Central Banks and market participants.

FX traders can monitor central bank announcements via the central bank calendar

Economic Impact of Unemployment

For the US, the Federal Reserve Bank (“The Fed”) relies on employment data when assessing potential adjustments to monetary policy . For example, if US unemployment rate is high, the Central Bank will look to boost the economy with expansionary monetary policy, which often entails reducing interest rates , which can make investing in growth that much more attractive given that rates (opportunity cost) are lower.

The knock on effect of expansionary monetary policy on economic output is demonstrated in the diagram below:

Employment to Inflation

On the other end of the spectrum, strong employment and low rates of unemployment do not necessarily spell for tighter monetary policy or higher rates. There is another factor of concern in that equation, and that’s when inflation begins to enter into the mix.

As the unemployment rate drops, businesses will have a more difficult time finding employees. This should lead to competition for those workers, and this will often show in the form of higher wages, which is considered as inflation.

Inflation is usually the bigger motivator for Central Bankers to hike rates and tighten policy, as this gives them reason for looking to protect the financial system from capital erosion via negative real rates and/or runaway inflation.

In the US, this is often followed through the Non-farm Payrolls report in terms of ‘Average Hourly Earnings (AHE).’

Employment Reports: Non-Farm Payrolls

The Non-Farm Payroll (NFP) report (released by the Bureau of Labor Statistics on the first Friday of every month at 08:30 EST) is one of America’s most influential economic announcements as it is seen as a direct representation of US economic growth. NFP is widely followed due to its early release, highlighting data for the most recently completed month and it’s often one of the first barometers that market participants have for that period. However, the unincorporated self-employed, unpaid volunteers or employees of family, farm workers and domestic workers are all excluded from NFP; and given the early nature of the report, it’s often subject to revisions in later months.

The NFP report comprises data from the Current Employment Statistics (CES) program from the U.S which surveys approximately 141,000 businesses and government agencies. This represents approximately 486,000 individual work sites, with the objective of providing detailed industry data on employment, hours, and earnings of workers on nonfarm payrolls, which accounts for 80% of the US workforce. Workers from the manufacturing, construction and goods sectors are included in the NFP report. The release of NFP, the US unemployment rate and Average Hourly Earnings (AHE) at the beginning of the month makes this data even more significant since it sets the tone for markets under the watchful eye of the Federal Reserve .

Economic Calendar

Daily FX, Economic Calendar

What is Contractionary Monetary Policy?

Contractionary monetary policy is the process whereby a central bank deploys various tools to lower inflation and the general level of economic activity . Central banks do so through a combination of interest rate hikes, raising the reserve requirements for commercial banks and by reducing the supply of money through large-scale government bond sales, also known as, quantitative tightening (QT).

It may seem counter-intuitive to want to lower the level of economic activity but an economy operating above a sustainable rate produces unwanted effects like inflation – the general rise in the price of typical goods and services purchased by households.

Therefore, central bankers employ a number of monetary tools to intentionally lower the level of economic activity without sending the economy into a tailspin. This delicate balancing act is often referred to as a ‘soft landing’ as officials purposely alter financial conditions, forcing individuals and businesses to think more carefully about current and future purchasing behaviors.

Contractionary monetary policy often follows from a period of supportive or ‘accommodative monetary policy’ (see quantitative easing ) where central banks ease economic conditions by lowering the cost of borrowing by lowering the country’s benchmark interest rate; and by increasing the supply of money in the economy via mass bond sales. When interest rates are near zero, the cost of borrowing money is almost free which stimulates investment and general spending in an economy after a recession.

Contractionary Monetary Policy Tools

Central banks make use of raising the benchmark interest rate, raising the reserve requirements for commercial banks, and mass bond sales. Each is explored below:

1) Raising the Benchmark Interest Rate

The benchmark or base interest rate refers to the interest rate that a central bank charges commercial banks for overnight loans. It functions as the interest rate from which other interest rates are derived from. For example, a mortgage or personal loan will consist of the benchmark interest rate plus the additional percentage that the commercial bank applies to the loan to provide interest income and any relevant risk premium to compensate the institution for any unique credit risk of the individual.

Therefore, raising the base rate leads to the elevation of all other interest rates linked to the base rate, resulting in higher interest related costs across the board. Higher costs leave individuals and businesses with less disposable income which results in less spending and less money revolving around the economy.

2) Raising Reserve Requirements

Commercial banks are required to hold a fraction of client deposits with the central bank in order to meet liabilities in the event of sudden withdrawals. It is also a means by which the central bank controls the supply of money in the economy. When the central bank wishes to reign in the amount of money flowing through the financial system, it can raise the reserve requirement which prevents the commercial banks from lending that money out to the public.

3) Open Market Operations (Mass Bond Sales)

Central banks also tighten financial conditions by selling large amounts of government securities, often loosely referred to as ‘government bonds’. When exploring this section, we will consider US government securities for ease of reference but the principles remain the same for any other central bank. Selling bonds means the buyer/investor has to part with their money, which the central bank effectively removes from the system for a long period of time during the lifetime of the bond.

The Effect of Contractionary Monetary Policy

Contractionary monetary policy has the effect of lowering economic activity and lowering inflation.

1) Effect of Higher Interest Rates : Higher interest rates in an economy make it more expensive to borrow money, meaning large scale capital investments tend to slow down along with general spending. On an individual level, mortgage payments rise, leaving households with lower disposable income.

Another contractionary effect of higher interest rates is the higher opportunity cost of spending money. Interest-linked investments and bank deposits become more attractive in a rising interest rate environment as savers stand to earn more on their money. However, inflation still needs to be taken into account as high inflation will still leave savers with a negative real return if it is higher than the nominal interest rate.

2) Effect of Raising Reserve Requirements : While reserve requirements are used to provide a pool of liquidity for commercial banks during times of stress, it can also be altered to control the supply of money in the economy. When the economy is overheating, central banks can raise reserve requirements, forcing banks to withhold a larger portion of capital than before, directly reducing the amount of loans banks can make. Higher interest rates combined with fewer loans being issued, lowers economic activity, as intended.

3) Effect of Open Market Operations (Mass Bond Sales) : US treasury securities have different lifespans and interest rates (‘T-bills’ mature anywhere between 4 weeks to 1 year, ‘notes’ anywhere between 2- 10 years and ‘bonds’ 20 to 30 years). Treasuries are considered to be as close as you can get to a ‘risk-free’ investment and therefore are often used as benchmarks for loans of corresponding time horizons i.e., the interest rate on a 30-year treasury bond can be used as the benchmark when issuing a 30-year mortgage with an interest rate above the benchmark to account for risk.

Selling mass amounts of bonds lowers the price of the bond and effectively raises the yield of the bond. A higher yielding treasury security (bond) means it’s more expensive for the government to borrow money and therefore, will have to reign in any unnecessary spending.

Examples of Contractionary Monetary Policy

Contractionary monetary policy is more straight forward in theory than it is in practice as there are plenty of exogenous variables that can influence the outcome of it. That is why central bankers endeavor to be nimble, providing themselves with options to navigate unintended outcomes and tend to adopt a ‘data-dependent’ approach when responding to different situations.

The example below includes the US interest rate (Federal funds rate), real GDP and inflation (CPI) over 20 years where contractionary policy was deployed twice. Something crucial to note is that inflation tends to lag the rate hiking process and that is because rate hikes take time to filter through the economy to have the desired effect. As such, inflation from May 2004 to June 2006 actually continued its upward trend as rates rose, before eventually turning lower. The same is observed during the December 2015 to December 2018 period.

Chart: Example of Contractionary Monetary Policy Examined

Source: Refinitiv Datastream

In both of these examples, contractionary monetary policy was unable to run its full course as two different crises destabilized the entire financial landscape. In 2008/2009 we had the global financial crisis (GFC) and in 2020 the spread of the coronavirus rocked markets resulting in lockdowns which halted global trade almost overnight.

These examples underscore the difficult task of employing and carrying out contractionary monetary policy. Admittedly, the pandemic was a global health crisis and the GFC emanated out of greed, financial misdeeds and regulatory failure. The most important thing to note from both cases is that monetary policy does not exist in a bubble and is susceptible to any internal or external shocks to the financial system. It can be likened to a pilot flying under controlled conditions in a flight simulator compared to a real flight where a pilot may be called upon to land a plane during strong 90 degree crosswinds.

What is Quantitative Tightening?

Quantitative tightening (QT) is a contractionary monetary policy tool used by central banks to reduce the level of money supply, liquidity and general level of economic activity in an economy.

You may be asking yourself why any central bank would wish to lower the level of economic activity. They do so begrudgingly when the economy overheats, causing inflation , which is the general increase in the prices of goods and services typically purchased in the local economy.

The Good and Bad Side of Inflation

Most developed nations and their central banks set a moderate inflation target around 2% and that is because a gradual increase in the general level of prices is integral to stable economic growth. The word ‘stable’ is key because this makes forecasting and future financial planning easier for individuals and businesses.

Inflation and the Wage-Price Spiral

However, runaway inflation can easily get out of hand when workers lobby for higher wages due to higher inflation expectations, a cost that businesses pass on to consumers via higher prices which reduces consumers’ purchasing power, ultimately leading to further wage adjustments and so on.

Inflation is a very real risk of quantitative easing (QE), a modern monetary policy tool comprised of large-scale asset purchases (usually some combination of government bonds, corporate bonds and even equity purchases) used to stimulate the economy in an attempt to recover from a deep recession. Inflation can result from over stimulation which may necessitate quantitative tightening to reverse the negative effects (surging inflation) of QE.

How Does Quantitative Tightening Work?

Quantitative tightening is the process whereby a central bank sells its accumulated assets (mainly bonds) in order to reduce the supply of money circulating in the economy. This is also referred to as ‘balance sheet normalization’ – the process whereby the central bank reduces its inflated balance sheet.

Objectives of Quantitative Tightening:

• Reduce the amount of money in circulation (deflationary)
• Raise borrowing costs alongside the rising benchmark interest rate
• Cool down the overheating economy without destabilizing financial markets

QT can be done via bond sales in the secondary treasury market and if there is a sizeable increase in the supply of bonds, the yield or interest rate required to entice buyers tends to rise. Higher yields raise borrowing costs and lowers the appetite of corporations and individuals that had previously borrowed money when lending conditions were generous and interest rates were near (or at) zero. Less borrowing results in less spending, leading to lower economic activity which, in theory, leads to a cooling of asset prices. Additionally, the bond selling process removes liquidity from the financial system forcing businesses and households to be more cautious with their spending.

Quantitative Tightening vs Tapering

‘Tapering’ is a term often associated with the quantitative tightening process but actually describes the transitional period between QE and QT whereby large-scale asset purchases are cut back or ‘tapered’ before coming to a complete halt. During QE, maturing bond proceeds tend to be reinvested in newer bonds, pumping even more money into the economy. Tapering, however, is the process whereby reinvestments are cut back and eventually come to a halt.

The terminology ‘tapering’ is used to describe the smaller incremental additional asset purchases which is not ‘tightening’ but simply easing off on the rate at which assets are being purchased by central banks. For example, you wouldn’t describe lifting your foot off the gas pedal as breaking even though the car will start to slow down, assuming you are on a flat road.

Examples of Quantitative Tightening

Since QE and QT are fairly modern policy tools, there really hasn’t been a lot of opportunity to explore QT. The Bank of Japan (BoJ) was the first central bank to implement QE but has never been able to implement QT due to stubbornly low inflation. 2018 was the only time the US implemented QT only to be discontinued less than a year later in 2019 citing negative market conditions as the reason for its abrupt end. In 2013, Fed Chairman Ben Bernanke’s mere mention of tapering sent the bond market into a spin, delaying QT until 2018 alluded to above. Therefore, the process is largely untested as the program was cut short.

Since 2008 the Federal Reserve has amassed $9 trillion on its balance sheet, only having reduced the figure slightly between 2018 and 2019. Since then, it has been one way traffic.

Accumulation of the Fed’s Assets over time (Peak just shy of $9 trillion)

Source: St. Louis Fed

The Potential Drawbacks of Quantitative Tightening

Implementing QT involves striking a delicate balance between removing money from the system while not destabilizing financial markets. Central banks run the risk of removing liquidity too quickly which can spook financial markets, resulting in erratic movements in the bond or stock market. This is exactly what happened in 2013 when the Federal Reserve Chairman Ben Bernanke merely mentioned the possibility of slowing down asset purchases in the future which resulted in a massive spike in treasury yields sending bond prices lower in the process.

US Treasury Yields Weekly Chart (orange 2yr, blue 5yr and 10 year yields)

Such an event is called a ‘taper tantrum’ and can still manifest during the QT period. Another drawback of QT is that it hasn’t ever been carried out to completion. QE was implemented after the Global Financial Crisis in an attempt to soften the deep economic recession that ensued. Instead of tightening after Bernanke’s comments, the Fed decided to implement a third round of QE until more recently, in 2018, the Fed began the QT process. Less than a year later the Fed decided to end QT due to negative market conditions witnessed. Therefore, the only example to go by suggests that future implementation of QT could very well result in negative market conditions once again.

Safe-haven currencies are currencies that tend to retain or increase in value during times of uncertainty and market instability. Safe havens tend not to have a correlation with the performance of stocks and bonds, making them ideal for trading in the event of market crashes.

In this piece, we’ll look at some of the safe-haven forex pairs traders may opt for, exploring why they offer protection and revealing how to trade them to protect against downturns.

What Qualifies as a Safe-Haven Currency?

When considering the question of what qualifies as a safe-haven currency, the factors to bear in mind can relate to the currency itself. These include strong liquidity, as well as to the wider economic climate in its issuing country – such as a stable political system, economic growth and stable finances.

However, these factors are not always fully reliable as indicators of a safe-haven currency. For example, the Japanese Yen is seen as a safe haven despite the country’s weak financial situation, which includes the highest government debt to GDP in the world.

Factors that actively undermine a currency’s safe-haven appeal should be considered by traders. One of these is that governments can intervene to stop a nation’s currency becoming too strong. An example of this is the Swiss Central Bank, which has on numerous occasions flooded the country’s market with Francs to protect exports.

The Japanese Yen experiences a similar pattern; it tends to soar during periods of global risk-off sentiment. As the country is so reliant on exports, the rising Yen can be problematic – when exports become less competitive, Japanese businesses are less profitable and equities can fall. As a result, Japan’s government may sell Yen and buy US Dollars, or, as in 2016, even adopt negative interest rates in an effort to maintain a depressed currency.

Top 4 Safe-Haven Currencies to Trade

The list of safe-haven currencies includes the Japanese Yen, the Swiss Franc , the Euro , and the US Dollar .

	US Dollar (USD)	Euro (EUR)	Japanese Yen (JPY)	Swiss Franc (CHF)
Rank (trading volume)	1st	2nd	3rd	6th
Percentage of global trades involving the currency*	88	31	22	6.9
Most commonly traded pair	EUR/USD	EUR/USD	USD/JPY	USD/CHF
Average amount traded*	$4.4 bn	$1.6 bn	$1.1 bn	$0.24 bn

*Net-net basis, daily averages for April 2016

Japanese Yen (JPY)

The Yen as a safe haven is driven by factors such as Japan’s strong current account surplus, positioning the country as the world’s largest creditor nation. Additionally, the Yen is a popular carry trade, meaning investors often borrow Yen from Japan, where interest rates are low, in order to buy currency in a country where interest rates are higher. This can push up the price of Yen during financial turmoil, as international speculators choose to unwind risky positions and pay back Yen loans.

In recent years, examples of the Yen’s appreciation include during the 2008 financial crisis , with the currency soaring against the British Pound and the US Dollar, the uncertainty of Brexit in 2015, and the 1998 near-collapse of the Long Term Capital Management Hedge Fund.

Since both USD and JPY are considered safe haven currencies, sometimes the USD/JPY market doesn’t move strongly, but a cross pair like GBP/JPY , AUD/JPY , and NZD/JPY often does.

US Dollar (USD)

The US Dollar ’s safe-haven status is maintained by the reliability of the US Treasury to pay its investors. Since the financial crisis, the received wisdom has been that, during times of market turbulence, investors sell risky assets and turn to US Treasuries and the US Dollar.

However, in recent years there have been instances when Yen and Euros have been the safe haven of choice over USD, and some analysts argue that there is little evidence that USD is being bought in meaningfully larger amounts than other safe haven currencies during economic difficulties.

Euro (EUR)

As with the US Dollar, disputes exist over the Euro ’s safe-haven status in today’s climate. The Euro has certainly displayed the hallmarks of a safe haven in past years – in 2015 analysts turned increasingly bullish on the Euro, driven by a positive outlook for selected European economies. Also, the low interest rates in major European economies led to expectations of the Euro acting like a safe haven.

However, in early 2018, following a plunge in US equities, the expected rush to buy Euros didn’t happen. It was business as usual for the Japanese Yen though, which did attract buyers.

Swiss Franc (CHF)

The safe-haven status of the Swiss Franc is underpinned by a stable Swiss government and a strong financial system. This is coupled with low inflation and high levels of confidence in the country’s central bank, the Swiss National Bank.

One example of CHF demonstrating its allure was 2011, when US Dollars and Euros poured into the Franc as nervous investors flocked for protection against the debt crises on either side of the Atlantic. This caused USD to slump against CHF from 0.9400 at the beginning of 2011 to 0.7900 by July, meaning one US Dollar could buy only 0.79 Swiss Francs. On the Euro side, in July 2011 EUR fell against CHF to around parity, from around 1.3000 at the start of the year.

As with the Japanese Yen, carry trade speculators like to leverage funds in Swiss Francs with no funding costs, paying back the loans when the position goes against them.

Using Safe-Haven Currencies in Forex Trading

When using self-haven currencies in forex trading, traders should be aware that some currencies, as discussed above, react differently to market events than others. Also, there is not always consensus on what currencies qualify as safe havens.

For example, while some view the Norwegian Krone as a safe haven, citing the country’s lack of net debt and its current account surplus, others believe that it is not the best option as it lacks liquidity and is too correlated to commodity currencies.

As well as using currencies for safe havens, gold is a popular consideration for traders looking to protect against excess risk. Gold is seen as a safe-haven because of its proven store of value, market utility and a price that generally isn’t influenced by interest rate decisions from central banks.

Whether going long on safe-haven currencies or choosing a higher risk strategy, make sure you access DFX Forex trading and educational guides to boost your confidence and skills, and refer to our news and analysis to stay up to date on currency pair movements.

Safe-haven assets are an essential antidote to economic downturns. They represent the markets that can protect traders and investors from losses when equities fall. Continue reading for our guide on the best safe-haven assets to choose, how they can safeguard your portfolio, and top tips for trading them.

What are safe-haven assets?

Safe-haven assets are where investors and traders put their money to protect against fundamental disruption. Safe-haven currencies , safe-haven stocks , gold , and US Treasuries have historically retained or increased their value during downturns or generally volatile markets, allowing protection against losses that growth equities may see in such conditions.

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Safe-haven assets will typically show most, or all of the following characteristics:

1) High Liquidity

With significant trading volumes, you can enter and exit positions at the price you want without experiencing slippage . An example of a highly-liquid safe-haven currency pair is GBP/JPY . When signs of fundamental disruption arise, such as a Western recession, a common move is to go short GBP/JPY – and being able to enter the position at the original price will potentially mean higher profits as the price falls further.

2) Limited Supply

If an asset’s supply outpaces its demand, its value will likely erode. Markets such as gold , which have a scarcity of supply, are likely to have value residing in that scarcity, and potentially higher value still when demand increases. See more on the forces of supply and demand .

3) Varied Utility

Does the asset have enough uses, for example in industrial applications, for it to have substantial demand? Copper , for instance, has a wide range of uses in infrastructure and agriculture in particular, and demand often increases when emerging markets ramp up development.

4) Enduring Demand

A true safe haven will be expected to retain demand in the future, so there should be confidence in an asset’s future utility. For example, while some commodities such as silver may have many industrial applications now, they may be replaced by other commodities for those applications in the future.

5) Permanence

An asset capable of deteriorating in quality may see lower demand in future as its utility declines.

The top safe-haven assets to trade

When it comes to trading safe-haven assets, you can choose currency pairs, US Treasuries, commodities and even defensive stocks. Here, we’ll look at some of the most common safe-haven assets to trade.

Gold

The most noteworthy safe-haven commodity is gold , which has historically shown a reliable negative correlation with stocks. This highly-coveted physical asset is in high demand, exists independent of monetary policy decisions, and has a tight supply.

In 2009 investors flocked to gold following the financial crisis , prompting a three-year bull run taking the price to $1,900/oz in August 2011. While the metal saw a torrid run in the two years to follow, a prolonged bear market beyond that was never sustained, reinforcing its safe-haven status. The chart below gives a picture of the main price moves since the turn of the century.

Japanese Yen

JPY is recognized as one of the most reliable safe-haven currencies due to its trade surplus and status as net creditor to the world, its demand in currency carry trade transactions, and the self-fulfilling prophecy caused by these factors. The chart below demonstrates three instances where the allure of JPY as a safe haven can be seen in risk-off markets over three decades.

Defensive Stocks

While growth stocks will often fall in wider market turmoil, there are certain safe-haven stocks that can retain or increase in value during economic hardship. That’s because selected companies in sectors such as consumer goods and utilities offer products and services that are in high demand even in difficult economic times. The chart below shows three examples of how McDonald’s weathered challenging economic storms this century.

US Treasuries

US Treasuries are considered safe havens due to their risk-free nature; the government repays these debt securities when the bills mature.

How to trade safe-haven assets

Now we’ve identified what markets to trade, how do you know how and when to trade them? Markets move in cycles, and traders should study the price of assets such as growth stocks, the US Dollar Index , and industrial major commodities , as well as fundamental factors such as employment data and GDP , to understand how the economy is performing. This will provide a better idea of when a downturn is likely to hit, and when to move a chunk of your portfolio into more defensive assets.

For example, three factors that may predict a downturn include:

1. An inverted yield curve for US Treasury bonds: While a downturn is not guaranteed when the yield curve inverts, this event does have a history of preceding recessions.
2. Poor business/consumer confidence data: If consumers and businesses aren’t confident about the economy, they are less likely to spend or invest for the future, which may cause contractions in growth, leading to downturns.
3. Negative employment statistics: Employment stats can give an insight not only into hiring intentions, but also number of hours worked. When companies cut hours or hire temporary workers, they may be nervous about the state of the economy.

Safe-Haven Assets: Key takeaways

1. Keep a close eye on the fundamentals: As discussed, fundamental factors such as employment statistics and business confidence can predict market downturns and economic prosperity alike. Accordingly, following as many fundamental factors as possible will give you a good measure of when to move into – and out of – safe havens.
2. Consider technical indicators: Indicators such as the Relative Strength Index will reveal when an asset moves into overbought/oversold territory. Combined with fundamental factors, this can give a clearer picture of when to enter or exit trades.
3. Historical price action matters: Bear in mind there will be times when a safe-haven asset may not behave as expected. For example, gold in 2008 might have been expected to soar as the financial crisis hit – but instead, reserves were cashed in by banks in favor of dollar liquidity. It was only the following year that the bull run began.

Further reading on safe haven investments

Looking to read more on safe havens that have greater macro scope and/or a stronger performance in ‘risk off’ environments? Read our guide to safe-haven currencies , and also don’t miss our safe-haven stocks piece for more specific strategies on the assets to consider when the markets get choppy.

Retail Sales: A Definition

Retail sales or the Retail Sales Index (RSI) is an economic indicator that serves as a gauge of the overall health of an economy by outlining consumer spending information. The report delivers an aggregate measure of retail goods and services spanning a months duration with the construct differing from country to country.

As an illustration, in the U.S. the major component of the retail sales figure are auto dealers which is why the Census Bureau report contains a ‘Retail Sales Ex Autos’ and ‘Retail Sales Ex Gas/Autos’ to eliminate any potential irregularity (volatility) from the auto industry – this exclusion is also referred to as ‘Core Retail Sales’ in some instances. Graphically, the data should present similar to the below economic calendar:

Source: Economic Calendar

Consumer spending is a key metric that drives economic activity so monitoring this data is essential for a company’s wellbeing as well as decision making (monetary and fiscal) going forward.

For example, when spending increases, business activity increases thus stimulating the economy and driving foreign investment. This in turn will impact other key economic components such as durable goods orders, consumer confidence, balance of trade, GDP and inflation to name just a few.

How is Retail Sales Measured? Examples of Retail Sales

The U.S. retail sales index comprises of various retailer types as shown below ( Source: U.S. Census Bureau ):

• Motor vehicle and parts dealers
• Furniture and home furniture stores
• Electronics and appliance stores
• Building material, garden equipment & supplies dealers
• Food and beverage stores
• Health and personal care stores
• Gasoline stations
• Clothing and clothing accessories stores
• Sporting goods, hobby, musical instrument & book stores
• General merchandise stores
• Miscellaneous store retailers
• Non-store retailers (online)
• Food services & drinking places

The above categories are then weighted and accordingly using a sampling frame predefined by the U.S. Census Bureau and is subject to periodic changes.

Retail Sales and Inflation

Positive retail sales data cannot always be taken at face value as the figure produced by the RSI is not adjusted for inflation . A positive figure once adjusted for CPI inflation can result in a net drop in retail sales. When inflation is high, the per dollar expenditure is reduced in terms of purchasing power which is why factoring in inflation is important for an all-inclusive representation of the economy.

How to Trade Retail Sales?

Trading retail sales is by no means straightforward but there are a few historical and noteworthy relationships between RSI and other markets. Beginning with the equity markets, retail sales traditionally exhibits a positive correlation to stocks because an increase in sales lends itself to higher company earnings. The graphic below shows how the U.S. equity markets ( SPX ) largely track fluctuations in retail sales data with an expected higher parallel with the retail sector as measured by the SPDR Retail ETF (orange).

U.S. RETAIL SALES VS S&P500 INDEX VS SPDR RETAIL ETF (2017 -2022)

Considering retail sales is largely comprised of auto sales in the U.S. (roughly 20% of the index), investors following the automotive industry can take clues from the motor vehicle sub category as to the current state and short-term outlook for local automotive manufacturers. The chart below outlines the rapport between the two variables by highlighting the positive correlation between retail sales data and two class leading manufacturers in Ford Motor Company and General Motors Company respectively. The same logic can be extended through to the other sub categories and utilized as an input for stock analysis in those corresponding fields.

U.S. RETAIL SALES VS FORD MOTOR CO. & GENERAL MOTORS CO. (2012 -2022)

Retail Sales in the Forex Market

As a general rule of thumb, improved retail sales usually translates to a positive for the home currency in question, while also adding to market volatility pre and post release. Following on with the U.S. as a template, retail sales data can have an influential impact on the central bank’s ( Federal Reserve ) decision making process. For example, if retail sales are slowing, the economic outlook may be considered bleak which may prompt the Fed to loosen monetary policy by cutting interest rates in hopes of stimulating the economy – the opposite will apply if retail sales are growing.

Supporting this positive correlation between currency and retail sales, the chart below shows a 6-month snapshot between U.S. retail sales data and the Dollar Index (DXY) . There is a clear positive association between the two variables but as with all financial market analysis, there are always other factors at play that need to be considered in the evaluation process.

U.S. RETAIL SALES VS DXY (2022)

Retail Sales: A Summary

Retail sales can assist traders regardless of trading style /strategy – technical analysis , fundamental analysis or a combination of the two. Understanding retail sales data can enhance one’s understanding of financial markets and the economics behind certain price movements. Retail sales can be incorporated across all financial market asset classes including stocks, FX, commodities and fixed income making it a great macro indicator for the broader market.

What is Consumer Sentiment?

Consumer sentiment, consumer confidence or the Index of Consumer Sentiment (ICS) is used as a barometer for overall economic health by market participants as determined by the consumer. The reading encompasses consumer and household opinion based on various survey questions including previous, current and future economic viewpoints on personal finances and the broader economy. The report will read similar to the economic calendar shown below and comprises inflationary prospects as well.

Source: Economic Calendar

Economic surveyors traditionally approached consumers and posed questions to them which are similar to the current set of questions shown below. The questions are meant to evoke opinions from consumers about their feelings with regard to their finances.

The consumer sentiment survey in the U.S. was created by Dr George Katona from the University of Michigan and first used in 1946, addressing the emotional state of consumers as opposed to purely quantitative metrics – hence the name ‘Michigan Consumer Sentiment’. The idea behind this type of survey is to try and understand how people make economic decisions in order to properly manage the countries policies. The questions below are designed to be timeless in that the survey would be fitting for people in the 1960s or the present day.

Source: University of Michigan

How to Read and Interpret the Consumer Sentiment Index

The consumer sentiment reading is quite intuitive and easy to read for the laymen. The results from the survey are collated and calculated to provide the different readings included in the report. The Index of Consumer Sentiment (ICS) is produced by using the formula shown in the image below. The formulas do differ between constituents but for the purposes of this article we will focus on the main print and formula.

Source: University of Michigan

The data is then graphically presented (see chart below) showing recessionary periods (grey) against the ICS – consumer sentiment can be suggestive of impending recessions. Simply put, the higher the sentiment number, the more confident consumers feel about their economic situation (and vice versa).

Source: University of Michigan

The consumer sentiment index is often considered a leading indicator as declining consumer data habitually precedes recessions.

Consumer Sentiment and its Relationship with Inflation

Inflationary pressures can be scary times for consumers as we can see in the 2020 – 2022 comparison chart below. The upward pressure on prices show a corresponding decline in consumer sentiment developing recessionary fears in financial markets. This knock-on effect does not make the job of central banks easy as the traditional monetary policy approach of hiking interest rates to quell inflation often leads to a further decline in consumer sentiment due to rising borrowing costs.

Understanding the mechanics of the consumer is key to properly manage monetary and fiscal policies. For example, when consumers ‘believe’ that inflation is unlikely to subside, the natural reaction function is to stockpile and buy more goods now to avoid paying higher prices later on. This then adds to higher inflation, highlighting the importance of central banks to instill confidence in the consumer that they will reduce inflation. The wording of central bank officials is extremely important to essentially persuade consumers in the direction they want for the desired outcome.

Source: Refinitiv

How to Trade Consumer Sentiment

MICHIGAN CONSUMER SENTIMENT VS S&P500 INDEX VS DXY (2017 -2022)

Source: Refinitiv

The chart above shows the relationship between U.S. consumer sentiment, the Dollar Index (DXY) and the SPX index respectively. Let’s now look at each one individually.

CONSUMER SENTIMENT IN THE STOCK MARKET

Historically, we have seen that U.S. consumer sentiment and the SPX have a somewhat inverse relationship as extreme drops in consumer sentiment are often succeeded by large upswings in the S&P 500 index. This is simple logic as a fearful market environment often poses opportunities for investors to capitalize on discounted stocks (cheap). The reverse is true in an overconfident landscape where the ‘smart’ or larger institutional investors tend to be fearful while greedy investors continue to invest resulting in significant downside once the market turns.

In summary, consumer sentiment can be used as a contrarian indicator for the U.S. stock market when it exhibits large variations. There are obviously exceptions to this rule of thumb depending on the context at that time where traditional economic principles sometimes fall out of sync.

CONSUMER SENTIMENT IN THE FOREX MARKET

From an FX perspective, U.S. consumer sentiment generally exhibits a positive association with the U.S. dollar. The theory suggests that a fall in consumer sentiment should lead to looser monetary policy to stimulate consumer spending on durable goods – lower interest rates should weaken the home currency (DXY) and vice versa. As mentioned under the stock market relationship, there are allowances for deviation. 2022 is a prime example of how this conventional relationship does not work. The fundamental backdrop in 2022 comprises high inflation, recessionary fears, geopolitical instability and declining consumer sentiment. In this case, the Federal Reserve maintained an aggressive/hawkish stance to combat inflation while consumer sentiment falls; allowing the dollar to strengthen from both a safe-haven standpoint and increase in interest rates.

Consumer Sentiment: A Summary

Consumer sentiment carries with it an insight into many other fundamental facets of an economy, leading to a better understanding of the financial markets. This leading indicator can be used as an important trading tool to enhance your trading style whether you are a fundamental or technical trader. At , we regularly cover consumer sentiment overviews and unpack what the data means for markets but if you are unsure about the principals behind certain economic concepts don’t hesitate to head back to out trading education section to build your knowledge.

What is Economic Growth and Why is it So Important?

Top news headlines are often dominated by the release of gross domestic product (GDP) figures and for good reason. The GDP release attracts a lot of attention from traders and market participants because of its signaling effect and ability to move financial markets.

This article explores the concept of ‘growth’ from an economic perspective and why it is beneficial for traders to have a solid understanding of the subject.

What is GDP Growth and How is it Reported?

When news outlets or financial publications refer to ‘growth’ they generally mean gross domestic product or GDP .

GDP measures the value of goods and services produced by a country in a given year and serves as an indication of economic health of that country. Essentially, it’s an objective measure of improving or worsening economic conditions in a particular country over time.

How is GDP Reported?

GDP has four main readings , one per quarter, often denoted as Q1, Q2, Q3 and Q4 ; but you may notice that GDP figures are reported every month. This is because GDP is a lagging economic indicator, meaning that there is a lag period before the data is collected, analyzed and adjusted to account for seasonal influences. Lagging economic indicators are not to be confused with lagging technical indicators .

GDP figures are mainly reported as a quarter on quarter figure (QoQ) or year on year (YoY). The below image shows the percentage change in real GDP * (QoQ):

*Real GDP provides a more accurate indication of production/output as it removes the influence of higher prices on the value of aggregated goods and services in the economy

There are three reported figures for each quarter:

1. The preliminary/advance figure
2. The second estimate and
3. The final GDP figure.

The preliminary/advance figure tends to have the biggest impact from a trading point of view as the other two figures generally involve small refinements to the initial figure. The component factors that make up GDP can often be observed and aggregated ahead of the released figure, meaning GDP is less likely to provide a shock to the market than other data releases such as Non-farm Payrolls (NFP) .

However, do keep in mind that for major economies an estimated GDP growth figure that differs from the actual by 0.3 or 0.2 percentage points can translate into billions of dollars -which may attract varying opinions of the state of the economy and result in elevated volatility after the release.

For more information on these releases, click the drop down arrow next to the event on the economic calendar

GDP Growth and the Signaling Effect

The state of the economy is watched very closely by governments and central banks . When the economic growth (GDP) is stagnant or the economy is technically in a recession, central bank policy shifts and becomes more ‘accommodative,’ providing liquidity and lowering interest rates ; while increased government spending often follows suit. In economic booms central bankers look to reign in overheating economies and monetary policy becomes more ‘contractionary’ in nature – raising interest rates, while governments often reduce spending.

Longer-term macro traders are able to analyze whether an economy is in a boom, recession or transitionary phase when planning trade set ups. Currencies linked to central banks that are ‘ hawkish ’ tend to appreciate at the start of an interest rate hiking cycle; while currencies linked to central banks that are ‘ dovish ’ tend to depreciate at the start of an interest rate cutting cycle.

For equities , lower future interest rates will make it easier for individuals and institutions to access credit at low rates which can be used to invest in the stock market. Additionally, lower interest rates translate into lower discount rates applied to future company cash flows to arrive at a higher valuation for shares in general.

For an in-depth understanding of the stock market, read through our comprehensive Understanding the Stock Market education section

Furthermore, traders are often able to pick up on clues on the direction of future monetary policy from the tone and language used by the heads of various central banks in their press conferences. Press conferences follow after an interest rate decision has been released.

Follow important dates for major central banks via our central bank calendar

GDP: Components of Growth

From an economic point of view, the main components of growth can be listed under the following broad categories:

• Consumption
• Investment
• Government spending
• Net exports

Output (GDP) = Consumption + Investment + Government spending + Net Exports

Consumption is the everyday exchange of money for goods and services such as buying groceries or paying your internet service provider. Investment refers to private local investment or capital expenditure, for example businesses will reinvest in the business to increase productivity and boost employment levels.

Governments spend money on infrastructure, equipment and salaries of government employees and this expenditure can look significant in times when general spending and business investment decline. Net exports is the result of taking total value of exports and subtracting the total value of imports and is the result of international trade.

Leading Economic Indicators of Growth

GDP growth is not the only indication of the state of an economy. While GDP is inherently lagging in nature traders can consider a whole host of leading economic indicators that can provide insight into the condition of different sectors of the economy before the GDP data is even released.

The data releases provided below also shed some light on underlying economic environment before GDP data is released:

• New building permits – This measures the change in the number of new building permits issued by the government. Building permits are a key indicator of demand in the housing market and the housing market/construction tend to move closely with the underlying state of the economy.
• Consumer credit – This figure has strong ties to consumer spending and confidence. Rising debt levels are usually indicative of economic strength as banks feel comfortable issuing approving lines of credit. On the other hand consumers feel financially stable enough to make the monthly repayments.
• Retail sales – Considered a primary gauge of consumer spending, which accounts for a sizeable portion of overall economic activity
• Consumer confidence – This measures the level of consumer confidence with respect to economic activity. It is a leading indicator as it can predict consumer spending, which plays a major role in overall economic activity. Higher readings point to higher consumer optimism.
• ISM Manufacturing/services PMI – Purchasing managers in any company hold the most current and relevant insight into their company’s view of the economy and therefore their sentiment of current economic conditions are of great value. A value above 50 indicates optimism while values below 50 are viewed as pessimistic.

Be sure to monitor these releases via the economic calendar

What is Inflation?

Inflation is the rise in prices of goods and services in an economy over a period of time, and is often displayed in percentage form. For example, if inflation is 2%, this suggests that prices are (on average) 2% higher than the previous period. Therefore, if a bottle of water cost $1 last year then this year it should be around $1.02. Inflation can result in significant costs to an economy as the purchasing power of individuals fall.

Deflation

Deflation is the opposite of inflation where prices fall. This suggests low demand for goods and services and often leads low interest rates. Deflation is atypical amongst developed countries.

Stagflation vs Hyperinflation

Stagflation occurs when an economy is stagnant (low growth ) but inflation is still prevalent. This can occur when external factors impact an economy such as the price of oil .

Hyperinflation is an extremely high rate of inflation within an economy. Hyperinflation can be caused by an increase in money supply which consequently results in increased consumer spending and higher demand for goods and services.

Both deflation and hyperinflation can be detrimental to an economy and can result in higher rates of unemployment and lower growth. This makes the role of central banks critically important to control inflation as a lack of stability may have the potential for destructive penalties.

Measuring Inflation

Consumer Price Index (CPI)

This is one of the more common ways of measuring inflation, calculating inflation is based on a basket of goods and services which are often referred to as a ‘cost-of-living index’. Common cost-of-living indexes are the Consumer Price Index (CPI) and Retail Price Index (RPI). These measures relate to inflation experienced by consumers on a daily basis. Each central bank faces unique headwinds in selecting appropriate items to include within their inflation calculation.

Core CPI vs Headline CPI:

Two common phrases when dealing with inflation is ‘core’ and ‘headline’ CPI. This differentiating factor between the two terms is quite simple. Core CPI refers to the omission of food and energy prices from the Consumer Price Index while headline CPI includes both food and energy prices.

Producer Price Index (PPI)

The Producer Price Index (PPI) focuses on inflation at the early stages of production which can provide essential information for manufacturers and industry. The chart below shows the historical comparison between the different inflation measures (CPI, PPI and GDP Deflator). It is clear that PPI is the most volatile which can be explained in part by producers being unable to pass on relatable costs to the consumer in difficult periods such as the global financial crisis .

GDP Deflator

Another way to measure inflation is via the GDP deflator which takes into account domestic goods only while CPI and/or RPI includes foreign goods, as well. A second key difference is that the GDP deflator method encompasses all goods and services while CPI and/or RPI only measures the price of goods and services bought by consumers. Because the GDP deflator is not restricted by a fixed basket of goods, it has an advantage over the others.

GDP Deflator = (Nominal GDP/Real GDP) x 100

Each measure has bespoke properties that may appeal to different individuals. Therefore, there is no ‘best’ way to calculate inflation but rather each measure has unique aspects that will be suited for different requirements and applications.

PPI vs CPI vs GDP Deflator

Source: World Bank

Sources of Inflation

Inflation can begin via many avenues in isolation or combination. Below are a few of the primary sources of inflation that can distress any nation across the globe:

Exchange Rates

A weakening local currency means that more local currency is required to purchase imports. This increased cost gets passed on to the end consumer which can contribute to inflation.

Essential Commodity Prices

Most manufacturers require inputs to produce a certain good. These often come in the form of commodities such as iron ore or oil . If these inputs increase in price due, then those costs can be passed on to consumers and the higher costs are a form of inflation.

Interest Rates

Lower interest rates theoretically lead to more spending by consumers, ultimately resulting in greater demand and cost of goods; which should lead to inflation, all factors held equal.

Government Debt

Increases in government debt may infer that there is a greater potential of a government default, which leads to higher yields on treasury securities to compensate potential investors for the higher risk. The effect this has on the public is that more tax revenue will be allocated to the higher interest payments on government debt obligations which reduces living standards. Businesses in turn increase the prices of goods and services to offset the lessened government expenditures, and this can lead to inflation.

The sources listed above generally fall into two broad categories of inflation which are:

1. Demand-Pull Inflation – This type of inflation comes as a result of an increase in aggregate demand inclusive of households, governments, foreign buyers and businesses.
2. Cost-Push Inflation – Supply is the driver of inflationary pressure for cost-push inflation. When supply falls due to higher production costs, the outcome is higher final prices for consumers.

Consequences of Inflation

Value of Money

The most obvious penalty of inflation from a consumer point of view is the higher cost of goods and services. This translates to a decrease in the value of money as individuals can now purchase fewer goods and services with the same amount of money prior to an inflationary rise.

Wealth Gaps

The inequitable distribution of inflationary pressure amongst individuals can lead to changes in wealth. For example, individuals with loans during periods of high inflation will benefit as the real value of their debt repayments will fall over time while others may not.

Inflation Volatility

Fluctuating or erratic inflation data complicates business operations as businesses do not know where to set prices, and this can have a negative effect on the economy as both businesses and consumers adjust to the higher rates of inflation. Long-term business deals will also incur higher costs as volatile inflation causes a higher risk premia on hedging costs, which can reduce foreign investor confidence.

Central banks use of Inflation Targeting

Inflation targeting is quite simple in theory as involves a central bank setting a specific inflation goal in percentage terms. This strategy is achieved by manipulating monetary policy . The goal of inflation targeting allows central banks along with the public to have more clarity in terms of future expectations. The reason behind inflation targeting is control with regards to price stability, and price stability can be attained by governing inflation.

Generally an inflation target of 1% – 2% is familiar as it allows governments and central banks some flexibility at this low base. As a rule of thumb, any deviation greater than 1% either side of the targeted figure is cause for concern and has generally lead to policy intervention.

How do Governments Control Inflation?

There are many ways governments go about controlling inflation which can have knock-on effects (positive and negative) to the economy depending on current economic conditions. The most common way is via contractionary monetary policy which is used by central banks to curb inflation by restricting liquidity. This is achieved via 3 main avenues:

1. Decrease Money Supply

Decreasing money supply simply gives consumers less money to spend overall and should help limit inflation. One way this can be realized is by increasing interest on sovereign bond payments which can attract more investors to buy bonds.

2. Reserve Constraints

Restricting the amount of money banks are allowed to keep can influence the amount of money being lent to consumers. That is, if banks are required to keep higher amounts of money as a legal threshold, then naturally banks will have less money to lend. This should decrease consumer spending and thus, inflation.

3. Raising Interest Rates

Higher interest rates which result in fewer individuals willing to borrow and therefore leads to a decrease in spending. There’s also a greater opportunity cost of investing capital into a business given the higher rates of return that could be had through capital markets.

Global Inflation and Key Relationships

Advanced vs Developing Economies

Source: World Bank

The chart above shows a consistent and logical pattern whereby the historical inflation rate in developed countries is generally less than emerging and developing economies (EMDE).There are two primary reasons behind this:

1. EMDE generally have higher growth rates which can lead to excess demand.
2. Volatile currencies are present in many EMDE which makes central banks’ management of monetary policy more difficult than those in advanced economies.

The Phillips Curve

The historical relationship between unemployment and inflation has been largely inverse which means that high levels of unemployment correlates with lower inflation and vice versa. The reason why the inverse relationship exists is best explained with basic economics. For example, an increase in aggregate demand which is a consequence of demand-pull inflation, results in higher prices of goods and services and lower unemployment. This lower unemployment means that there is more income available in the economy to spend on goods and services. Both elements have recurrent effects on one another and is best represented by the basic Phillips Curve (see chart below).

Source: Created by Warren Venketas

Inflation: Conclusion

This article has demonstrated the wide reaching implication of inflation from more concentrated effects to wide-ranging systemic global impacts. Inflation is an important economic tool from a macroeconomic perspective but also can be powerful if understood and implemented within a trading strategy as inflation data can cause changes in price in many financial markets.