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The Basics of Fundamental Analysis

In determining a trading strategy, traders use tools that can be broadly categorised into one of two kinds of methods of analysis: technical or fundamental.

While opinions on either differ, there is no definitive answer on a “better” trading strategy. Each method of analysis has its own merits, and different traders favour different methods based on their trading habits. Some even combine the two.

Fundamental Analysis is the study of the cause of market movement. This means determining the intrinsic value of an instrument based on real-world circumstances micro and macroeconomic factors like war, recession, interest rates, and political unrest.

Fundamental analysis is a method of evaluating an asset. It attempts to measure its intrinsic value by examining the underlying forces that could affect the asset.

Fundamental analysis includes:

  • Geopolitical factors such as interest rates and other government policies
  • Macroeconomic factors such as the level of unemployment
  • Company or industry-specific factors such as mergers or acquisitions

Through fundamental analysis, we can determine the overall health of an economy to give us a mid to long-term outlook on the direction of the markets. This is because fundamental analysis measures an asset’s intrinsic value. There is an assumption that every asset has a “correct” price, from which we can determine whether an asset is currently over or undervalued based on its market price.

Keeping in mind that the prices tend to revert to what is “correct”, knowing whether the asset is under or overvalued gives us an indication as to whether to buy or sell.

What to Look Out for when Performing Fundamental Analysis

Central bank activity

A central bank refers to a body that manages the currency and monetary policy of a country. Central banks make decisions that affect the economy, which in turn, impacts markets. When central banks make an announcement, it pays to listen closely as there’s a high chance it might be something important.

Below is a list of a few major industrialised nations and their central banks.

USA – Federal Reserve System

Commonly known as the Fed, its current chairman is Jerome Powell. The Federal Open Market Committee (FOMC) is the Fed committee to look out for as it makes decisions about Treasury bonds, monetary policy, interest rates, and operations in the foreign exchange market.

Europe Union – European Central Bank (ECB)

Headquartered in Germany the ECB services the Eurozone, as well as the European Union and its member states. Its current president is Christine Lagarde.

UK – Bank of England (BoE)

The United Kingdom’s central bank’s current governor is Andrew Bailey. In charge of the state’s monetary policy is the Monetary Policy Committee, or MPC, which meets 8 times a year to decide the official interest rate.

Japan – Bank of Japan (BoJ)

Japan’s central bank holds its monetary policy meetings 8 times a year. Its current governor is Haruhiko Kuroda.

Interest Rates

Understanding interest rates is important when talking about factors such as money supply or inflation because central banks manipulate interest rates to control the money supply and combat inflation.

The interest rate can be defined as the cost of borrowing money expressed as a percentage of the loan value.

Why is this important? Changes in a country’s interest rate strongly impact the economy, which in turn affects the markets.

Increasing interest rates effectively makes it harder to borrow money. As a result, spending goes down, which causes demand for goods to go down. As a result, prices decrease, which cools the economy down and staves off overinflation.

Meanwhile, decreasing interest rates has the opposite effect. It becomes easier to borrow money, and the amount that people and businesses spend goes up. This increases demand for goods, and consequently, their prices.

Central banks will often increase interest rates when they fear that the economy might be overheating or growing too quickly, resulting in a situation when production cannot keep up with demand.

Meanwhile, central banks will lower interest rates when they feel that the economy is facing a potential recession. Interest rates will be reduced to encourage spending and promote the growth of the economy.

Money Supply

The main role of any central bank is to control a country’s money supply.

Money supply refers to the measure of all the paper currency, coins, loans, credit, and other liquid instruments in circulation within a country’s economy.

By decreasing borrowing costs, central banks are effectively increasing the money supply.

How is “money” defined?

There is no one universal consensus as to what constitutes money. Different economic systems have their definitions, with most using a classification based on a range of “M”s where M0 is the narrowest measure, with subsequent numbers indicating broader definitions.

In the US Federal Reserve System, for example, M0 refers to currency in circulation outside of bank vaults; while in the Eurozone, M1 refers to the currency in circulation, plus overnight deposits. Meanwhile, in the US, the broadest definition is M3, which includes a range of instruments including cash, savings deposits, time deposits, and other liquid assets.

For traders, the money supply is an important factor, especially for those trading FX.

The money supply, also sometimes called money stock, is thought to impact inflation, price levels, and the business level. For example, increasing the money supply usually decreases interest rates, which, as we’ve discussed, stimulates spending and thus economic activity.

On the other hand, if a country’s money supply outstrips economic output, then inflation can happen as the prices of goods rise. 

Inflation

Inflation is the rising cost of goods and services. It causes an erosion of the purchasing power of money. This means that the worth of your money goes down as inflation increases.

There are two main causes of Inflation:

Demand-Pull Inflation occurs when aggregate demand outweighs aggregate supply. When there is more demand than supply, prices increase, resulting in inflation.

Cost-Push Inflation occurs because of an increase in the cost of intermediate goods or services. These can include raw materials or wages. This leads to higher costs for the finished product, which contributes to rising consumer prices.

There are multiple ways to measure inflation, with one of the most popular being the Consumer Price Index (CPI), which measures the weighted average of a basket of common, necessary goods and services. There is also the Producer Price Index (PPI), which measures the average change in the selling price of goods and services, from the perspective of the sellers.

Inflation is a double-edged sword. Steady, controlled inflation might help increase production, but high inflation will cause the price of goods to rise out of control. Inflation also affects assets differently. Currency-denominated assets like cash or bonds will lose value due to inflation, while hedges against inflation like gold or other commodities are usually independent of, or rise with inflation.

Economic Releases and Events

Periodically, countries will release or publish data about market-moving events. These can include economic data or news of a qualitative or quantitative nature.

This information helps paint a picture of the overall health of a company or country’s economy.  A stronger outlook for a company or country’s economy should be reflected by a higher company stock price or stronger domestic currency, which will most probably impact the financial markets.

This impact can be short and/or long term, and traders will be looking to benefit from any movement created by these economic data releases. Investors will make decisions based on their interpretation of information that has been released.

Key Points of Economic Data

  • The key to trading based on economic data is to look at the outcome of the data/news release versus the expected forecast.
  • The larger the difference between the actual figure and the forecast figure, the greater the likelihood of a larger change in prices.
  • The importance of the data will also be a factor in determining the strength of price movement.

For example, the U.S. Non-Farm Payroll (NFP) is a figure that’s released monthly and measures the number of jobs created or lost each month, excluding farm workers, private household employees, or non-profit organization employees.

If the forecasted figure of the NFP is -65k, and the actual figure is -131k, it means that over twice the expected number of people have lost their jobs. Based on this figure, there will most likely be a reactionary sell-off on the US dollar.

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