How Macroeconomic Events Can Filter Down into Personal Investing
Analyzing and utilizing the J-Curve Effect when deciding in which industry, sector, or even country, to invest.
It is common knowledge that since the mid-1970s, the majority of world economies have adopted freely floating (flexible) exchange rates, which have considerable bearing on how international trade is conducted, as well as on a country’s macroeconomics.
J-Curve Effects: Short and Long Term
For example, when a domestic currency depreciates, prices of imported (foreign) goods and services increase in the short-run. Consequently, domestic exports increase, while imports typically decrease.
This, in turn, pushes the real gross domestic product (GDP) closer to its potential GDP, at times even surpassing it, all the while increasing prices of domestic goods and services, creating initially a domestic inflationary ripple effect.
In the long-run, however, this inflationary ripple effect is expected to automatically stabilize itself, as domestic consumers adjust to the fact that foreign goods and services have become price elastic.
(Note that the demand for a price elastic good is highly correlated to its price fluctuations. In contrast, when a good is price inelastic, it means that the quantity demanded of the good changes little or not at all when its price fluctuates.)
And, as consumers accept the fact that foreign goods are going to be more expensive in the long-run, they revert to buying less expensive domestic products.
This phenomenon is called the J-Curve Effect, since, when data is presented graphically, the curve literally looks like a letter “J.”
The next logical question is what happens when domestic consumers ignore J-Curve’s natural progression and stick to more expensive foreign goods, in spite of the domestic currency depreciation and in spite of the fact that domestic goods, after initial inflationary pull has subsided, have become de facto cheaper?
In other words, what happens if there is an anomaly in the development of the J-Curve and if prices of imports become and remain inelastic?
The likely result of this economic development is identical to what has been happening, for example, in the automobile industry in North America in the past few years.
It appears that North American consumers care very little about generally higher price levels of Toyotas and Hondas, for instance, in comparison to domestically manufactured vehicles by Detroit’s Big Three (GM, Ford, and Crysler).
Judging by revenue figures, consumers are still very much partial to buying imported cars, partly due to their personal tastes, and partly due to their pockets being somewhat deeper as the real GDP continues to grow at moderate, yet relatively sustainable annualized rates.
As a result, foreign car prices appear unable to adjust to the J-Curve progression and remain stubbornly inelastic.
To illustrate, not only did Ford post its 2th consecutive decline in monthly sales in December, but Chrysler also ranked the third for the first time in over a century. To add insult to injury, according to Autodata Corp., Ford outsold Toyota by a narrow margin of 18,000 vehicles in 2016.
Evaluate Specific Sectors, Industries or Economies
But how can J-Curve help ordinary investors to evaluate industries or sectors that spark their interest?
Granted, compiling, plotting, and graphing data to figure out whether a J-Curve is observable, is generally something that investors cannot do on their own.
However, the good news is that there is plenty of information, independent studies of specific sectors, industries, and even entire economies that are available for your use on the Internet.
For instance, if you are interested in the U.S. manufacturing sector, simply plug into your search engine words identifying the sector of interest and add words “J-Curve Effect.” In most cases, related studies have already been completed and will pop up on your computer screen.
The same can be done to evaluate emerging economies, such as China, India, or Brazil. Check out what experts have to say about the J-Curve Effect; it could be extremely useful when forecasting future price trends in sectors and industries that interest you.
(Source: Economics, 12th Edition, by Michael Parkin)