What do we mean by the phrase ‘gross domestic product’, how is it calculated and what does it mean for investors.
GDP or Gross Domestic Product. Not the most illuminating of phrases, but it is one of the primary indicators used to gauge the health of a country's economy alongside inflation and unemployment. And not just a nation, it can also be used to take the economic pulse of industries, regions, and even the entire world. This can help investors when deciding which countries or industries on which to focus their research activities.
In this focus article we look at what we mean by the phrase ‘gross domestic product’, how it is calculated, and what it means for governments, central banks, businesses and investors.
What is GDP?
GDP represents the total value of all goods and services produced or consumed over a specific time period. For this reason it is often referred to as the "size" of the economy.
There are four figures we need to consider:
Nominal GDP is the simple sales value of all economic activity. It is used to make comparisons with other economic variables that do not make adjustments for inflation. For example the debt-to-GDP ratio helps economists understand how ‘affordable’ government debt is relative to the size of the economy. As the level of government debt is independent of changes in retail prices, it is compared to nominal GDP.
Nominal GDP also makes comparisons between nations easier as they experience different rates of inflation.
Real GDP adjusts nominal GDP for the effects of inflation (rising prices) or deflation (falling prices). It provides a more realistic assessment of growth than nominal GDP, which could give the impression that the economy is growing even when it is only prices that have gone up.
Real GDP is usually reported on an annual basis to remove the effects of short-term seasonal activity such as Christmas spending.
GDP per capita or per person, is GDP divided by the number of people in the population. It is often used as an indicator of living standards. It is also the best way to compare GDP across countries with very different population sizes when converted to a standard currency (usually dollars).
GDP growth is the percentage change in levels of real GDP (i.e. excluding price increases). It shows how fast an economy is growing (expanding) or shrinking (contracting).
Why is it important?
Understanding what the GDP data tells us about an economy can have a large impact on nearly everyone.
Once a long series of GDP figures has been collected, they can be analysed to identify business cycles. These are alternating periods of expansion (boom) and contraction (slump). By understanding where an economy currently stands in relation to these cycles, governments, businesses, economists, and investors seek to anticipate the near-term and long-term future trends.
GDP and investors
GDP data can help investors understand which economies are doing well and which less well, guiding the asset allocation decision.
Within each economy, it highlights which sectors and industries are benefitting from existing conditions, thereby informing their sector exposures.
It also provides a guide to how governments and central banks are likely to frame short-term policies and this can help investors identify the kinds of businesses that could benefit from these policies, or which might suffer.
The next sections explore these in more detail.
GDP and businesses
Economic growth creates more profit for businesses. As a result, share prices rise, giving companies more capital to invest and to hire more employees. As more jobs are created, unemployment falls and incomes rise. Consumers have more money to buy additional products and services. Purchases drive higher economic growth. And so the cycle continues.
But if an economy is contracting, businesses suffer reduced earnings and lower share prices. They delay investing and hiring until they can be confident the economy will improve. Those delays further depress the economy. Without jobs, consumers have less money to spend.
GDP and government policies
A growing economy increases tax revenues. If growth is stalling, the government will try to find ways of boosting activity and confidence in the economy. This is generally achieved through spending on infrastructure: large-scale projects that help countries become more efficient at moving goods and people.
This activity helps civil engineering, construction, transport and logistics firms and, by extension, their employees and the allied trades and suppliers that these industries support. Eventually, the government investment to pay for these upgrades flows into the general economy.
Counter intuitively, the government could decide to cut tax rates to encourage specific activities (like business investment in new machinery) or to encourage spending more generally.
But if either of these measures fail it could lead to a high debt-to-GDP ratio. Investors may become concerned that they won’t be repaid or see a return on their investment, and will be put off investing in the economy.
GDP and central bank policies
Central banks use the GDP growth rate to decide whether to encourage or discourage spending by companies and individuals.
If the growth rate is meagre and the economy appears to be stalling, the central bank may decide to reduce interest rates in an attempt to encourage corporate borrowing for investment.
During a recession the central bank might decide to go further. It might buy government and lower-risk rated corporate bonds from banks using freshly printed money which enters the economy, boosting the amount available to spend. This action also reduces borrowing costs because the increased demand for bonds increases their prices and reduces the effective interest rate. In theory, more people and businesses will then buy or invest. Demand for goods and services will rise and, as a result, output will increase.
To cope with increased levels of production, unemployment levels should fall and wages should rise.
If the growth rate looks to be accelerating aggressively, a central bank might decide to increase interest rates to forestall a rapid rise in inflation. To restrict borrowing further, the central bank might decide to sell its stock of bonds. This will increase the supply of bonds, pushing down prices and resulting in higher interest rates. This would reduce borrowing and investing, and reduce demand.
Central banks regard the ideal not-too-hot, not-too-cold level of growth as being somewhere between 2% and 3%. A growth rate of more than 3% or 4% implies the economy is expanding at an unsustainable pace. A negative growth rate indicates that the economy is shrinking and in recession.
How is it calculated?
GDP can be measured in three ways and in theory, no matter which method you chose you should come to roughly the same figure.
The output measure is the value of the goods and services produced by all sectors of the economy; agriculture, manufacturing, energy, construction, the service sector and government.
The expenditure measure is the value of the goods and services purchased by households and by government, investment in machinery and buildings. It also includes the value of exports but subtracts imports to reflect local production.
The income measure is the value of the income generated mostly in terms of profits and wages.
How frequently is it reported?
GDP figures are reported quarterly, and it is not uncommon for the data to be restated from time to time. This is due to the involved processes required to collect the data.
Each quarter’s first estimate (called the "flash") may only include 40% to 50% of the information needed and is based on the output method. It is followed by two subsequent revisions at monthly intervals. The final figure will be based on all three calculations to provide a picture of the economy that is as accurate as possible.
But this isn't the end. Revisions can be made as late as 18 months to two years after the first flash estimate.
Forecasting GDP growth
What ultimately determines output is demand. In attempting to predict future trends, economists and investors try to focus on the respective levels of the four GDP components:
- Personal consumption
- Business investment
- Government spending
- Net trade This is why some surveys are widely anticipated. These ‘forward indicators’ can act as proxies for, or presage, official data releases.
This is why some surveys are widely anticipated. These ‘forward indicators’ can act as proxies for, or presage, official data releases.
Consumer sentiment surveys and retail sales figures are a proxy for personal consumption. House prices can often be used as a forward indicator because the majority of a household’s personal wealth is tied up in the value of their home. If house prices are rising, consumers feel ‘wealthier’ (even if that increase in wealth is not easily accessible) and increase their spending plans or bring them forward.
Employment data and wage reports also help build a picture of potential consumer demand.
The Purchasing Manager’s Institute (PMI) surveys are also important data releases. This is because these surveys can help us understand the business environment for different parts of the economy.
Business sentiment surveys can provide further insights into future investment and hiring plans.
Different economies have different relative weights between these sectors. In the UK, and in most of the developed world, the services sector is the largest contributor to the economy. For others it can be agriculture, mining and energy, or manufacturing.
By multiplying the value of each element of GDP by its proportional presence in the economy, economists hope to get a ballpark idea of how the economy is faring.
GDP has its limitations
Whilst GDP is a good proxy for economic health, and allows comparisons across different countries, it only measures what a society values.
GDP doesn't usually include unpaid services, omitting child care, unpaid volunteer work, bartered goods or services, and illegal or black-market activities. For countries where major business transactions are informal agreements, portions of the economy are not registered resulting in abnormally low GDP figures.
GDP doesn't count the environmental costs that are created by industrial activity but borne by society at large. For example, the price of plastic is cheap because it doesn't include the cost of disposal; nor does GDP measure the effects of air and water pollution, nuclear waste, and deforestation.
GDP doesn’t recognise quality or efficiency improvements and innovation. Today’s computers are less expensive and more powerful, thereby allowing users to achieve more at a lower cost. But GDP treats them as equivalent products by only counting the monetary value, and this understates economic growth.
GDP is an overall figure and does not account for the distribution of income among the residents of a country. An economy may be highly developed or growing rapidly, but also contain a wide gap between the rich and the poor in society.
The performance of the economy is important to all of us and of the three measures that indicate how well an economy is doing, GDP is the most important.
For businesses, it can help them understand whether to invest in new machinery and an increased work force. Will consumers have enough money to buy the products, or will the products sit on shelves and collect dust?
For consumers, can they rely on continuing incomes? How secure are their jobs and are they likely to get a pay rise?
Although it is consumers who ultimately determine the direction of the economy, governments and central banks can influence it through their policies on spending, taxation, interest rates and money supply.
For investors, it can help understand where future opportunities and risks are likely to come from. It therefore helps frame their investment decisions at the country, sector and individual company level.
Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise. No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.
Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions. Any views expressed within this report are our in house views as at November 2018 and should not be relied upon as fact and could be proved wrong. The information contained in this document has been derived from sources which we consider to be reasonable and appropriate. This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.
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