You’ve probably heard of gross domestic product, or GDP as it’s often mentioned in the news. It measures the health of a country’s economy, and is an indication of a population’s standard of living.
At big economic events like the Autumn Budget and Spring Statement, the government is judged on the strength of GDP – and a stumble can easily steal headlines away from any giveaways.
It underpins our outlook on the health of financial markets and is obsessed by analysts and policy makers alike, but how does it impact you and your money?
What is GDP and what does it measure?
UK GDP reflects the size of the UK economy by measuring the total value of everything produced by the people, businesses and government within it.
It’s essentially the total value of all the products and services produced within a region over a specific period of time – whether that’s on an annual or quarterly basis.
When GDP increases, the economy is rising; when it falls, the economy is contracting. After two consecutive quarterly falls in economic growth, the economy officially enters a period of recession.
Why is the economy important?
The economy plays a pivotal role in our standard of living.
If an economy is growing, consumers spend their money on goods and services, businesses reinvest the profits and creates more jobs, and the government spends more money on new initiatives.
In a healthy economy unemployment is low and wages are rising, whereas in a bad economy earnings are lower and unemployment is higher.
If one of these economic inputs falls and no other parts of the chain can cover the decline, GDP will decrease, which will impact the standard of living of the population.
How is GDP measured?
GDP is calculated by adding together consumer spending, business investment, government spending and the difference between imports and exports.
Thus, the equation goes like so: C + I + G + (X – M).
Now, measuring GDP is complicated and we leave the specific number crunching to the experts. Still, we know there are three ways you can calculate GDP, each of which should result in the same number.
- The Income Approach – Add up what everyone earns
- The Expenditure Approach – Calculate what everyone has spent
- The Output Approach – Measure the value of output from goods and services
The raw aggregate calculation is called the nominal GDP, however it’s difficult to compare GDP over time as it doesn’t factor in the impact of inflation.
That’s why the number crunchers at the Office for National Statistics adjust the numbers to account for inflation; this is known as real GDP. This figure is then used to calculate GDP growth rate between quarters and years.
To compare economic growth reliably between countries, analysts divide the aggregate figure by the number of people in the economy to get GDP per capita. Otherwise, a nation with more people in it may produce a larger GDP just because it has more consumers to spend money.
GDP can also be a reliable indicator of productivity within a country. Whilst GDP is one of the broadest measures of economic growth, it’s not very timely and later revisions to estimates can alter historical data.
How GDP impacts you
GDP also informs business decisions – whether to expand production or cut back, for example. For this reason, investors are very interested in the health of the economy, as this feeds into their return on the financial markets.
Governments and central banks use GDP to decide monetary policy and government initiatives, which impact everyone.
Providing a quantitative GDP figures helps policy-makers decide whether to stimulate a stagnant economy with cash, or turn off the cash taps in an economy that’s in danger of overheating.
If the Bank of England decided to stimulate a stagnant economy, they might loosen monetary policy by cutting interest rates and introducing quantitative easing (QE) – where new money is created to buy investments like government bonds.
This would be bad news for savers as the returns on their savings accounts will reduce, although borrowers will enjoy access to cheap money.
An economy that’s overheating may need slowing down by hiking interest rates or scaling back QE – slowly reducing the amount of money being created to nothing.
Whilst savers will be relieved to earn more from their cash savings, unprepared borrowers may encounter some trouble keeping up with repayments.
It’s important to remember that GDP is calculated by compiling aggregate numbers, the effects of positive GDP growth isn’t split equally to everyone. Whilst some enjoy the fruits of a healthy economy, others will struggle.
How does GDP impact your investments?
Economic growth acts as a good springboard for investments on the stock market. When consumers and governments spend more, company profits will rise.
These profits will be reinvested by companies in a bid to drive profits even higher over time. Higher earnings mean better equity valuations – in theory.
Although there’s a correlation between GDP and stock market performance, the theory is by no means infallible.
Gone are the days when companies operated in just one country, for example. Today, a corporation will have businesses across the globe, so its value will be influenced by all of the economies it works in.
Investors should use economic growth rates, both historical and forecasts, to influence the asset allocation within their portfolio. Keep in mind that just because an economy has performed well, doesn’t mean it will forever.
Diversifying your investments across geographies will help reduce your exposure to one economy; if one economy is in trouble you can hope to benefit from growth elsewhere. Diversification across investments and asset classes can also help manage risk in portfolios and provide a hedge against weaker economic growth.
As GDP is a strong gauge of economic sentiment, it plays a crucial role in the financial markets and has a strong impact on everyone within it. It’s important you analyse economic trends like this and make long-term forecasts to ensure the mix of investments in your portfolio accurately reflects you and help you achieve your financial goals.