When you read news reports that say the economy’s doing well or poorly, it’s almost always the case that GDP, or Gross Domestic Product, is cited as a key statistic. We’ve asked two experts to explain what GDP is and why it should interest investors like you.
What is GDP?
Craig: GDP is a dollar measure of the value of all final goods and services produced in a particular period. Typically the periods are broken into month over month, quarter over quarter and year over year.
Kavcic: GDP is a measure of the total value of economic output in Canada.
How is it calculated?
Vice-President and Director at TD Asset Management
Senior Economist and Vice-President, Economic Research at BMO Capital Markets
Craig: There are a number of methods used to count GDP. There is the production approach (total produced), the income approach (total earned) and the expenditure approach (total spend). All three measures should roughly equal the same number. [People in the investment industry] tend to focus on the expenditure approach, since the components of the formula […] pertain to investing. The formula is as follows:
GDP is the sum of consumption, investment, government spending and net exports.
Consumption: Typically the largest component of developed economies, it consists of household final consumption expenditures. These expenditures fall under durable goods (cars, furniture), non-durable goods (food, personal products) and services (medical check-ups, haircuts).
Investment: Non-Residential (tools, software, factories), Residential Structures, and Change in Inventories (inventories are the difference between goods produced and sold)
Government: Defense, Non-Defense (education, bureaucracy)
Kavcic: Statistics Canada derives it based on various inputs (see below for more).
Why do economists track it?
Inflation refers to an increase in the price of goods and services, which reduces the purchasing power of money.
Craig: Nominal GDP, which is not adjusted for inflation, is used to measure the economic performance of a country or a particular region. It is also important as a means of [determining] whether there are inflationary pressures building in the economy.
Kavcic: The quarterly real GDP report gives the broadest information on the health of the economy and is used as the reference point for determining expansions and recessions. The breakdown into personal expenditure, business investment, net exports and government spending illustrates the key drivers of real GDP. Another key element is final domestic demand, which excludes external trade and inventories.
Why do investors track it?
Craig: There are a number of reasons why investors pay attention to GDP. One is to glean clues about the future direction of monetary policy. Weaker-than-expected GDP performance tends to signal looser, more simulative policy; stronger GDP [signals] the opposite. […] Secondly, investors care about the performance of the components of GDP. Strong consumption performance is good for consumer staple and discretionary equities (e.g., grocery stores and luxury brands, respectively), while strong investment performance is supportive of industrials and capital goods producers (e.g., railway companies and manufacturing equipment producers, respectively).
Kavcic: GDP provides a broad snapshot of economic growth. Faster economic growth could imply stronger profit growth for businesses, which is a plus for the equity market. The pace of economic growth can also signal future moves in interest rates for bond investors.
Craig: A recession is defined as two consecutive quarters of negative GDP growth.
Kavcic: In its most basic form, two quarters in a row of negative GDP growth. However, a true recession (unlike what we saw in 2015) will typically see deep and broad-based declines in economic activity across a wide range of sectors and regions.
Craig: A recession preceded by a recession and a quarter or two of positive growth. The last double-dip recession in the U.S. was in 1982.
Kavcic: An economy that briefly emerges from recession, but then subsequently contracts again.
Craig: A prolonged economic contraction. Depressions are characterized by large increases in unemployment and very difficult credit conditions (i.e., when loans are difficult to come by). Bankruptcies become common both on the private and sovereign level.
You should also know…
“The modern concept of GDP,” notes Craig, “was developed in the 1930s and there is some debate about whether it is as relevant in today’s economy, although it is still widely used.”
Kavcic: A sustained long-term decline in economic activity. As in the 1930s, this is typically associated with long-term declines in financial markets, sustained high jobless rates, deflation and contracting of credit.
Craig: An economic phenomenon in which an economy experiences growth while employment levels stagnate or even decline. There is no agreed upon cause of this phenomenon. Some economists have argued it is the result of gains in productivity through automation while others argue that they stem from structural changes in the labor market (e.g., major demographic changes, government benefit policies that discourage re-entry into the workforce, mismatch between skills of workforce and skills required).
Kavcic: Sometimes an economic recovery will begin (i.e., business will start producing more) before hiring begins to increase at a meaningful rate. As in recent cycles, businesses have squeezed productivity out of existing employees very early in the cycle, but job growth usually follows.