You may have heard or seen the term GDP appear often in the news lately. Specifically, you may have grown accustomed to hearing the term ‘UK GDP’ being followed by words like falling, collapsing, shrinking, or contracting for example, due to the current Covid-19 crisis.
But what does GDP mean, and how do its variations affect you?
What is GDP and what does it measure?
GDP stands for Gross Domestic Product and it essentially corresponds to 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.
GDP is typically used to measure the health of a country’s economy, and is considered an indication of a population’s standard of living. 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.
A decrease in GDP is typically accompanied by higher rates of unemployment, lower earnings, and a worse standard of living overall.
How is GDP calculated?
There are three ways to calculate GDP, each of which should result in roughly the same number.
- The Income Approach – The total sum of earnings (mainly profits and wages)
- The Expenditure Approach – The total sum of expenditure (of households and governments)
- The Output Approach – The value of all goods and services produced by all different sectors of the economy
The raw aggregate calculation is called the nominal GDP. However, it is 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, which is often presented in the form of a percentage.
The Bank of England uses GDP to set interest rates for its member banks – a tool it uses to affect the economy.
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How does GDP affect investments?
Increasing GDP, and consequently economic growth, acts as a positive springboard for investments on the stock market. When consumers and governments spend more, company profits rise.
These profits are reinvested by businesses in a bid to drive profits even higher over time. Higher earnings signal 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 is 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. Just because an economy has performed (or is performing well), doesn’t mean it will forever.
Diversifying investments across geographies reduces exposure to a single economy; if one economy is in trouble, it is possible 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. Although important, it isn’t always simple to analyse such economic trends and make accurate long-term forecasts regarding the economy.
Luckily, Moneyfarm does this for you, matching you with an investment portfolio that will help you reach your long-term financial goals.