Make Sense Out of Economic Data—Avoid Analysis Paralysis

 
by Brian Dolan

Virtually every day, potentially market-moving economic data reports are released by the world’s major economies.  It might be German industrial production, Chinese trade data, US personal spending, or even all three.  How is a regular investor supposed to make sense of it all?  More importantly, should you make any adjustments to your investment strategies based on the numbers? It’s easy to just shrug and ignore economic reports, but you may be missing some important signals somewhere down the road. You don’t have to be an economist to make sense of all that data if you’re able to factor it in to the big picture and what it may mean for your investments. Here’s a quick framework to digest the data and what it might mean for the investment environment.

 Prioritize the Economic Data

Economic data reports can be broadly grouped into four categories based on the segment of the economy they cover:

  1. Labor Market reports (jobs are the key to the economic outlook)
  2. Consumer level reports (consumption accounts for 70% of activity in major economies)
  3. Business level reports (business spending and investment makes up most of the rest)
  4. Structural level reports (broad economic indicators, such as GDP or inflation)

 Put the Economic Data in Perspective

The first rule to remember is that no single weekly/monthly/quarterly report makes a trend. Investors should look at the history of the data series, such as the last 3-6 months to discern if there is any meaningful pattern developing, either positive or negative.  For example, if a nation’s unemployment rate increases more than economists and markets expected, it may be due to a statistical glitch or a one-time event, such as a labor dispute.  On the other hand, if that same country’s unemployment rate shows a rising pattern over several months, labor market conditions could be seen to be weakening, carrying risks for the economic outlook and the performance of financial investments in that country.

 Adjusting Asset Allocation

Depending on the interpretation of any trend in the data series, positive or negative, investors might consider altering their asset allocations based on the overall implications for financial market performance. For example, if incoming data paint a picture of an improving consumer environment (e.g. job creation increasing, consumer confidence rising, wages growing, retail sales improving, etc.), an investor may decide to allocate more investments toward risk assets (stocks in general, consumer-focused sectors in particular) and away from more conservative investments, such as cash or bonds.  In another example, if housing data begins to show signs of weakness over several months, an investor might reduce or exit real estate investments. By the same token, if an investor does not hold any real estate assets, but thinks it’s a good long-term investment, a decline in real estate assets could provide that investor with an opportunity to invest at a lower cost.

 

Applying the Big Picture

Clearly, there are myriad potential scenarios that can play out in economic data, financial markets, and investing. For the economic data, the key is to understand what it covers and what it says about the big picture. It’s also important to remember that economic data is frequently backward looking, so markets tend to pay more attention to the most current and forward looking data indicators. To keep incoming data in perspective, it’s helpful to focus on two main issues:

  • What Does the Data Say About the Growth Outlook?

The key to understanding the growth outlook is to remember the importance of each economic sector as it relates to growth. Personal consumption is responsible for 70% of all economic activity in most developed economies, the other 30% primarily from business activity. Hence, strong personal consumption reports such as retail sales, will usually indicate stronger growth in an economy. Growth of the overall economy as a whole is a positive sign for investors. As the economy grows, the stock market may rise as well.

The history of data plays a large role in the growth outlook of the economy. One months’ report that deviates from the current economic trend does not necessarily signify a change in economic outlook. Although many short-term investors may worry, we are concerned with long-term economic growth as investors. Do not get so caught up in the previous GDP report – worry about where the economy is heading.

 

  • What Does the Data Say About the Interest Rate Outlook?

Job reports and GDP reports are an excellent indication for how fast an economy is growing. If GDP is increasing too fast, or the job report significantly beats estimates, there may come a point when inflationary pressures build up as labor and productive capacity near full utilization. In this event, the central bank may conduct a stricter monetary policy, so as to “cool down” the overheating economy and head off inflation. As interest rates rise, companies and consumers might decrease their spending, and the economy could decelerate.

The opposite may occur when the economy is stagnant, or is contracting. The central bank’s monetary policy will loosen to decrease interest rates. Lower interest rates are sought to generate an increase in borrowing, investing and spending, hopefully resulting in job creation more consumption, and stronger economic expansion.

 

Personal Investment Style Considerations

The final major piece of the puzzle centers on an investor’s individual investing style.  No two investors are alike, and consequently how they respond to economic data will depend on their particular investing approaches.  Long-term investors, for instance, may decide only to change their strategies if incoming data indicates a substantial, long-term change (several years) in the direction of an economy or sector.  If retail sales show a few months of weakness, for instance, but most other data series are stable (jobs, wages, housing, confidence, etc.), a long-term stock market investor may decide to stay invested and ride out any accompanying market setback. Alternatively, if an investor thinks a housing bubble has formed and real estate data begins to show signs of weakening, they might decide to reduce or exit real estate investments for a while.

Shorter-term investors, or those who seek to “time the market” (buying dips/selling rallies), may look to react more quickly to what incoming data reports suggest, seeking an opportunity to re-enter their preferred investing strategy in the future.  Based on incoming data, they also may be more active in adjusting asset allocations (shifting between stocks and bonds, for example) or sector allocations (shifting between cyclical and defensive sectors).

No matter your individual investing style, a solid framework to make sense of major economic data reports will make you a more informed investor and improve your potential for financial success. Resist the temptation to tune out the stream of economic data. Instead, prioritize the data, put it in perspective, and see how it fits in to the bigger picture and what that might mean for your investment strategy. Then you can more confidently adjust your investments as circumstances change over time.