Gross Domestic Product

Study Notes:

GDP is the market value of all new goods and services produced within the economy. It’s used globally as a report card of how large an economy is and the speed at which it is growing or contracting at. GDP is comprised of four major segments: Consumption, Investment, Net exports and Government Spending. Consumption represents all purchases made by consumers and is split further into sub-categories of non-durable goods, durable goods and services. Investment represents the money businesses are spending on growth, along with residential investment by households. Investment is split into the sub-categories of non-residential investment, residential investment and the change in private inventories. Net exports is the balance of trade and could be negative when there’s a trade deficit, as one exists in the U.S., when the market value of imports exceeds the market value of exports. Government spending represents Federal defense spending, federal non-defense spending along with state and local spending. GDP is calculated at The Bureau of Economic Analysis or BEA by using a mix of estimates from professional trade organizations and government agencies. The report is generally published quarterly on the last Thursday of the month, one month after the referenced quarter at 8:30am eastern time. Additionally, two GDP revisions are published later when more accurate information is available. The BEA provides GDP data so that investors, Congress, policymakers, business and community leaders have the information necessary to make informed decisions that affect the American economy.

GDP is the foundation of financial markets globally. Market participants generally pay attention to the quarter over quarter, seasonally adjusted annualized rate of change in real GDP. This headline number is critical because it adjusts for seasonality, for inflation and tells us how fast the economy is growing, or if an economy is in or heading towards a recession. A decline in real GDP by definition, means an economy is in recession. In aggregate, companies can’t grow if GDP is declining. It means there are less transactions and less incentives to invest. GDP is used globally and can be useful when analyzing which economies are growing the fastest or the slowest.

When Real GDP is expanding, the positive ripple effects are felt across the economy. Companies have an incentive to invest, consumers want to spend and governments can collect taxes from the transactions. This leads to progress across many areas such as more people working and earning higher wages, more companies growing revenues and profits, and additional fiscal flexibility for governments. The U.S. makes up four percent of the global population but a whopping 25 percent of global economic activity. If GDP in the U.S. is declining, there’s a high probability that GDP will decline around the world, due to the massive influence U.S consumers, businesses and investors have. Higher real GDP growth likely leads to higher stock prices, higher interest rates, higher investment returns, and greater happiness and prosperity. Lower real GDP growth is likely to lead to lower investment returns and a reduction in opportunities for individuals, businesses and governments.

To forecast GDP, look at leading economic indicators such as unemployment claims, housing permits, purchasing managers’ index for manufacturing, durable goods orders, retail sales, the yield curve, the money supply, and consumer confidence which provides a powerful predictive insight as to the direction of economic growth. These leading indicators cover labor layoffs, capital-intensive manufacturing and real estate sectors, strength and sentiment of consumers and businesses, along with the amount of inflationary pressure in the pipeline, and finally, the level, positioning and balance of interest rates.

In general, higher interest rates and tighter credit conditions slow down economic growth and may lead to recessions. Historically speaking, Central Banks have had plenty of difficulty attempting to engineer “soft landings”. Soft landings occur when an economy is overheating and central banks tighten policy to cool the economy while avoiding recession. When central banks start raising rates, there’s a chance that a recession will follow because it’s challenging to tighten policy with the precision necessary to avoid economic contraction.

GDP may be the main driver of market direction if there’s a surprise in either direction. Some market participants use leading indicators as a predictive guide of GDP.

GDP is a barometer for opportunity and prosperity. Monitoring changes in the economy and analyzing the acceleration, deceleration or reversal of GDP is important when making investment selections globally. Fast economic growth will likely lead to fast financial asset growth. Financial asset values won’t sustainably grow if GDP is declining.