Gaining an understanding of gross domestic product (GDP) is important for investors because it can affect how the financial markets behave, both positively and negatively. In most cases, strong GDP growth translates into higher corporate earnings, which bodes well for the stock market. Conversely, falling GDP means economic growth is weakening, which is negative for earnings and therefore stock prices. According to the classic definition, a recession occurs when there are two consecutive quarters of negative GDP growth.
For bond investors, the direction of GDP often has the opposite effect. Strong GDP growth usually means a greater demand for borrowing by businesses and consumers, and is often a sign of impending inflation. This usually translates into higher interest rates, which depresses bond prices. Conversely, declining GDP generally means lower inflationary pressures as well as lessening demand for borrowing, which then generally means lower interest rates and higher bond prices.
What Is GDP?
GDP represents the total value of all goods and services produced in a country. It's considered the measurement of the size of a country's economy, and one of the primary indicators of a country's standard of living.
GDP growth is often used as an indicator of the general health of an economy. Not surprisingly, when it rises, the economy is typically deemed to be doing well. Employment can be expected to increase as companies hire more workers, which means people have more money to spend. This then generates more business, and keeps the cycle going.
When GDP is shrinking, the opposite occurs: businesses cut back on production and expansion, and workers are laid off. Quite often, as we've seen in the years following the Great Recession, GDP doesn't grow fast enough to incent businesses to expand and hire more workers, which in turn feeds the stagnant or downward cycle.
By tracking the ups and downs of the economy, investors can make appropriate financial investment decisions.
No Direct Correlation
While GDP growth does influence the financial markets, investors shouldn't try to directly correlate GDP growth, whether positive or negative, with stock market or bond market returns. There is a connection between the strength of the overall economy and the financial markets, but it's typically rather loose and evident only over very long periods of time.
For one thing, GDP is a lagging indicator, meaning that it shows what the economy did in the past, albeit fairly recently. In the U.S., GDP for one calendar quarter is not released by the Bureau of Labor Statistics of the U.S. Commerce Department until the end of the following month. In addition, the initial report is subject to two subsequent revisions.
However, investing is largely a forward-looking process. Investors buy or sell stocks and bonds based on what they think the direction of future GDP growth will be, and how it will affect their individual investments, not how it has performed in the past. While past performance may provide some indication of how the economy is likely to perform in the future, there is no guarantee that the future will follow along the same pattern.
What Directly Affects Stock And Bond Prices?
Moreover, while there is some correlation between stock market returns and a country's GDP, that correlation is limited and holds true only over very long periods. Many things go into determining the price of stocks, GDP being only one of them.
GDP also may have little bearing on the value of individual investments, which is more directly determined by:
- supply and demand for that stock,
- dividends and stock buybacks,
- mergers and acquisitions,
- the quality of management
- and many other factors.
Indeed, there has been little direct correlation between GDP growth and stock prices in the years 2007 to 2017. In the wake of the 2008 financial crisis in the U.S., the S&P 500 plunged more than 40%, while nation's GDP growth declined by about nine percentage points from its peak growth rate in 2005 to its lowest point in early 2009, when the economy shrank by 2%.
Since then, stock and bond prices have risen sharply even as GDP growth has been both weak and uneven globally. In the U.S., for example, GDP growth averaged less than 2% annually since the global recession in 2008, while the S&P 500 more than tripled with an average annual gain of more than 27%, not including dividends.
A large reason for those increases in stock and bond prices has been the unprecedented actions of central banks, including the Bank of England, the U.S. Federal Reserve, the Bank of Japan and the European Central Bank. These institutions have kept short-term interest rates at or near zero for eight years while purchasing massive amounts of government, corporate and mortgage bonds in order to drive down long-term rates. Those policies were intended to make bonds and other fixed-income instruments less attractive by lowering their yields, thus pushing investors into riskier investments such as equities.
Because GDP growth has been so weak over the past decade, many corporations saw fit not to invest in growth in their own companies or hire new workers. Rather, they retained earnings, repurchased their own stock or increased their dividends, which also pushed stock prices higher.
Why GDP Doesn't Correlate With Investment Returns
Theoretically, according to some analysts, investment gains should more closely correlate with GDP growth. After all, they argue, the underlying economy drives corporate profits and therefore earnings per share, which eventually determines the price of a company's stock. Over the long-term, aggregate corporate earnings rise when the economy grows or vice versa.
However, this only works when a country's economy is closed, valuations remain constant and if only domestic companies are listed on a country's stock market. Of course, we live in a global economy, where many, if not most, publicly traded companies operate in many countries. As a result, their activity is affected by business conditions, laws, interest rates, tax and monetary policy, currency values and other factors in each place.
GDP is an important measurement of a country's economic growth, health and size, and does influence the direction of the financial markets. However, many things impact the price of individual investments, many more closely and directly than GDP does. Because many companies operate in various international markets, their fortunes are tied to the dynamics of multiple economies, not just one.