Fundamental analysis and Technical analysis
In our articles focusing on strategy, we emphasised the importance of finding a balance between fundamental analysis and technical analysis. Fundamental analysis refers more to macroeconomics, while the latter refers to technical aspects only or, in other words, graphs and their interpretation. In this article we discuss some regularly used terms that can also create some confusion: recession, inflation, deflation, stagnation, stagflation. It is vital to know them well, not only from an educational standpoint but also so we don’t make mistakes when trying to understand a reaction immediately after an announcement that could influence market prices. If for example, Draghi comes out with a new deflation figure, we need to know what this means so that we can act accordingly, should the figure have an influence on a particular title, such as a currency pair.
Macroeconomic data often influences currency pairs, since they depend on the value of individual currencies, which in turn represent the wealth of a given economy. For this reason, we can well understand how a healthy economy has a stronger currency than an economy in recession.
Take note that when we speak of a currency and the economy of the relevant country, we could be referring to either one single country (eg, US dollar for the USA), or a group of countries (eg, the Euro for Europe). The difference between the two is that while a negative or positive situation in one single country will have a profound influence on its currency, in a group situation the influence of one state or country will have a more diminished effect on the currency’s trend. If, for example, Italy is in a recession, its relevant stock index will be affected, while the Euro, comprising of more countries, will be affected to a much smaller degree. In this example of Italy being in a recession, the Euro could count on other countries to maintain its value.
By “recession”, we mean an economic situation in which production levels are lower than what they could be when using all productive factors at their disposition completely and effectively. More specifically, we speak of a recession when there is negative growth in GDP (Gross Domestic Product) for two consecutive quarters in an economic cycle lasting between 6 and 18 months. In the USA, however, there is a recession when the GDP declines for two consecutive quarters. In any case, the first definition is considered the most accurate as it is the more widely recognised of the two.
What constitutes a Recession: A recession is obviously a negative factor that impacts undesirably on the economy, causing a depreciation of the currency, especially in the case of it lasting for an extended period. In the case of a currency pair, we take into consideration the fact that it is a relationship between two economies. Therefore, if both economies are in recession, the spread is reduced, or it could actually remain the same.
Inflation refers to a prolonged increase in the average level of prices, with consideration given to what may be regarded as a “long time”, even though the reference is usually made to monthly data. A rise in inflation generates a decline in the purchasing power of the currency, thus causing a general decrease in demand. With prices being higher, there is less purchasing of goods and services compared to when prices are lower, which is why inflation tends to affect consumers the most. When inflation is caused by a rise in the price of raw materials it is called “Agflation”.
What constitutes Inflation: The issue of Inflation is more complex than that of Recession. In fact, Inflation can be viewed as either a negative or a positive situation. If an increase in prices is combined with unweakened purchasing power, it means that the economy of that country is strong, healthy and therefore will have a strong currency (especially in the case of “single” countries). Nevertheless, even a strong country can have export problems if they ask for higher prices, since their offers will have to compare with lower-priced competition.
On the contrary, if there is inflation combined with a weakened purchasing power, then this is an unmistakeable symptom of a struggling economy.
Deflation is the opposite of Inflation. It is in fact a decline in prices, usually caused by a reduction in credit availability. As you can imagine, if one situation is positive for the consumer, the other creates a negative spiral for the profits of companies at risk of financial difficulties, closure, layoffs, which means unemployment and so forth. Think about those countries for example, where you can “buy everything at super-low prices”. When examining this type of situation, it is easy to see that the country would not be considered economically healthy.
Stagnation refers to an economic situation in which there is a “dead calm” in the GDP and in the income per capita. It is not a recession in that there is no decline, but simply a persistent situation of nongrowth.
Stagflation is a term that combines Stagnation and Inflation, usually accompanied by high unemployment. It refers to a complex situation which creates a dilemma for governments lasting several years. Stagflation made its first appearance in the 1960’s, because before then chief economists believed it to be an impossibile scenario. Its appearance even created a predicament for the famous Keynes and his “General Theory of Employment, Interest and Money”. The man to oust him was Milton Friedman, the “founding father” and foremost exponent of “Monetarism”.
Economics history aside, this new situation put Western governments to the test, as they had to do battle with something they had never come across before. It is effectively a stalemate, where the central banks need to reduce the money supply in order to limit the demand for goods and services; something which does not promote economic growth and would therefore see a return in unemployment.