Introduction to fundamental analysis
What is fundamental analysis?
Unlike technical analysis, which looks purely at price action and trends, fundamental analysis takes on a much more rigorous assessment of an asset, such as a commodity or currency to build up a more holistic picture of its strengths and weaknesses.
Looking particularly at the forex markets, fundamental analysts look at key elements that are likely to have a bearing on the strength or weakness of a particular currency, such as economic data, political factors and even the impact of natural disasters.
A simple analogy illustrates how fundamental analysts work; in property investment, you might buy a house on expectations that its price might rise in value because it is in a high-growth area. A fundamental analyst however, would look at the house’s foundations, insulation, history, previous tenants, the surrounding schools, nearby shopping centres and scope for improvements in the surrounding area before deciding to invest.
Put simply, fundamental analysts use every piece of available data to help them gauge the strength of a particular asset.
For example, fundamental analysts pay particular attention to the release of key economic data and reports such as unemployment and GDP data, interest rate announcements and production data to determine the future direction of a currency's price movement whilst share traders would look at earnings reports.
Key factors of fundamental analysis
Company earnings form a crucial part of fundamentally analysing whether a current share price is undervalued or overvalued.
Fundamental analysts can also get guidance on profit projections from earnings reports while looking at key contributing elements to the bottom line, and then use this information to ascertain whether a company could outperform or underperform in their future earnings.
Natural disasters, such as flooding, hurricanes and tsunamis can have a major impact on the fundamental strength and weakness of an asset.
For example, the 2010 tsunami in Japan had a debilitating impact on the region's manufacturing sector, which caused significant disruption to the production of mobile technology and automakers. At the same time, the tsunami also increased expensive insurance claims which weighed on the balance sheets of major insurance firms.
Economic growth and output
The key indicator of economic growth is Gross Domestic Product (GDP), which calculates the sum of goods and services produced within the country. It’s one of the most important indicators of economic growth and output, which tells us about the economic strength and performance of the country.
Key indicator 1: Consumer Price Index (CPI) measures the change of the average price of goods and services paid by consumers. It’s a major indicator adopted by governments for inflation targets and has a significant impact on setting interest rates.
Key indicator 2: Producer Price Index (PPI) measures the changes in the price of goods and services at the producers’ level.
Interest rates have a direct impact on currency rates. The demand on the currency with a higher yielding interest rate is often greater than the one with a lower interest rate.
As the demand for goods and services from a particular country increases, demand for the country’s currency also goes up. This means the value of the currency will appreciate (rise).
Political crisis and uncertainty in a country often have a negative impact on the demand for the currency. When a country is politically unstable, investors’ confidence in its economy tends to decrease.
Fiscal policies, such as budget planning, government spending and taxation encourage or discourage productivity and spending in the economy, and therefore have a major impact on the currency markets.
The monetary policy adopted by Central Banks has a big influence on the near-term demand for currencies.
If, for example, the Bank of England adopts a hawkish monetary policy, this indicates that interest rates are set to rise and may increase the demand for the pound sterling, which could therefore appreciate as a result. (Hawks generally favour using relatively high interest rates to help keep inflation in check.)