What Is GDP and What Can Investors Learn From It?
The Gross Domestic Product, or GDP, is the total monetary or market value of all goods and services produced in a country within a specific time period. It is essentially a way to put a number on the strength and size of a country’s economy.
The U.S. has the highest GDP in the world at about $22.68 trillion, with China ringing in at number two at about $16.64 trillion as of April 2021, according to the International Monetary Fund.
The GDP can be broken down in the following equation: C+G+I+NX=GDP
C: The C is for consumer spending. Consumer spending accounts for all personal and household spending on goods and services. Consumer spending also includes any services people purchase, such as getting a haircut or getting your oil changed.
G: The G is for government spending. This category includes any goods or services the government purchases. For example, this includes everything from public workers’ salaries, fixing roads, to any military-related spending. Basically, the only forms of government spending that are not included in this category are transfer payments (such as social security or unemployment).
I: The I is for investments. There are three main types of investments included in this category: non-residential investments, residential investments and change in private inventories. Non-residential investments account for any private domestic investments companies are making within their own country. For example, a company is considered to be investing when it buys new tools, machinery or additional factories.
A residential investment accounts for the construction of new living accommodations (such as single-family housing or multi-family housing). The investment can be made by an individual for personal use or by a landlord for occupational use. The investment is only included when the house is originally built or when any home improvements are made to the house. Thus, when an owner of a house sells it to someone else, the only transaction that would be included would be a potential broker’s fee or any additions the previous owner or new owner did.
The final form of investment is a change in private inventory. This category accounts for any additional inventory a company has at the end of a specific time period (typically the quarter or year) that they did not have prior. For example, if I own a rug store and bought 1,000 new rugs at the beginning of the year but was only able to sell 600 rugs, the 400 rugs left over would count as the change in private inventory.
NX: The NX is for net exports. To find the net exports, you subtract the total imports purchased by a country from the total exports it sold in a specific time period. This could include anything from cars to coffee to diamonds.
There are different forms of GDP
Actual GDP: The actual GDP can be reflected in either the real GDP or the nominal GDP. The real GDP is adjusted for inflation, while the nominal GDP is not.
Potential GDP: The potential GDP is a theoretical number that estimates the output a country is capable of sustaining if operating at maximum efficiency. Economists will compare the potential GDP to the actual GDP to arrive at the output gap, which demonstrates if the economy is producing more or less than its capacity.
Another key statistic that people will cite is the GDP growth rate. The growth rate indicates the change in GDP from the preceding period. A positive growth rate tells us that the economy is expanding, while a negative growth rate tells us that the economy is shrinking. The National Bureau of Economic Research will use a negative growth rate as an important indicator as to when the U.S. is entering a recession.
The GDP is an indicator of the health of the economy
If you think about the factors that go into calculating the GDP, it makes sense that the GDP is an indicator of a strong economy. Take the United States for instance – consumer spending makes up around 70% of our GDP. High consumer spending means people are putting their money back into the economy, as opposed to saving it. When people trust the state of the economy, they feel more confident to spend their money.
But the GDP doesn’t tell the full story.
A high GDP does not always indicate a thriving country; it doesn't account for economic inequality, for example. Two countries can have the same GDP, but one country could have a couple of super wealthy people and the majority of people in poverty, while the other country could consist of everyone earning about the same average income. These countries could hypothetically be reflected as the same in the GDP.
Another common criticism of the GDP is that it doesn’t account for non-market transactions. The GDP is not able to include transactions that are not reported -- this can include anything from exchanges in the black market to a childcare provider not reporting his/her income.
The GDP also doesn’t take into account the sustainability practices of a country. Countries can be exploiting natural resources, but the GDP would only account for the goods and services the country is producing.
So, while the GDP can be a great indicator of the size and strength of an economy, it is important to remember that it can be misleading. When looking at the “success” of a country’s economy, it’s important to factor in not only the goods and services it produces, but the general lifestyle the country is promoting.
The preventative measures a country is taking to sustain its resources may not significantly impact its current GDP but will definitely impact its future. Similarly, don’t overlook the economic inequality in a country just because it has a high GDP. Individual economic success is just one part of having a successful country.
So, why should investors care about the GDP?
When making investment decisions, it is important to not only look at the performance of a specific company but to look at the general health of the economy. The GDP provides a strong indicator as to a country’s economic strength. Let’s say an investor is considering investing in a company in a country outside the U.S. -- they may consider the country’s GDP. If a country’s GDP is low, it is likely that the country’s stock market is also weak. Investors can also look to the GDP growth rate to analyze trends of a country’s GDP. The growth rate will help provide insight into whether the country’s economy is shrinking or growing, and whether it is at risk of experiencing a recession or inflation. These are all factors that can impact the stock market’s performance, and thus, investment decisions.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.