Why Investors Should Pay More Attention To Economic Growth

Why Investors Should Pay More Attention To Economic Growth

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The increase in a country’s production of goods and services is generally referred to as growth or economic growth. Three macroeconomic aggregates are largely used to measure an economy's performance: employment, inflation and Gross Domestic Product (GDP). 

This post will focus on GDP and, specifically, the US economy. The Bureau of Economic Analysis, or BEA, provides a quarterly estimate of the real GDP growth rate in the US, with a monthly estimate for the quarterly measure available in the form of advance, preliminary and final estimates. The advance estimate often generates the most attention for investors in the markets (particularly if it deviates outside of market forecasts, which can also elevate volatility across the financial markets) as it is the first glimpse of how the economy performed in the previous quarter. 

Measuring the size of a country’s economy usually falls on GDP growth, defined as the total dollar value of all final goods and services produced within a country’s borders over a specific period, usually a year. To be clear, economists and investors tend to focus on real GDP, using constant prices (that is, GDP measured in base year prices) rather than nominal current prices. 

All economies experience expansionary and contractionary phases, referred to as the business cycle (or the economic cycle) Constructed through four phases: expansion, peak, contraction and trough, economic activity, or real GDP, naturally experiences swings and troughs, or periods of growth and recessions. Given the stock market generally leads economic activity (leading indicator), economic expansion (contraction) is usually accompanied by a bull (bear) market (you will find many refer to this as the financial cycle).

Why is Economic Growth Important for Investors?

Growth in an economy, or economic output, is important for not only investors but also individuals, corporations, policymakers (who use GDP to help formulate economic policy) as well as developing nations. Economic growth can improve living standards and decrease poverty, while absent economic growth, the economy can eventually enter a recession (loosely defined as two negative quarters of real GDP) or, worse, a depression. 

With an economy displaying growth, investors will typically expect corporate earnings to follow suit. A growing economy leads to increased economic activity in some major sectors, translating into higher demand for companies' products and services. It is common to see technology and consumer discretionary stocks turn higher in advance of an economic expansion, followed by communication services stocks and industrials. As the stock market transitions to a bull market phase, this tends to lead to energy stocks rallying also. And when an economy is expanding, investor confidence generally rises, leading to increased risk appetite. This translates into a willingness to invest in riskier assets like equities, with the expectation of higher potential returns. An economic slowdown has the opposite effect and can trigger risk aversion, prompting investors to ditch equities and consider safe-haven markets, such as bonds. 

Interest rates are also affected by economic growth (or lack of). In periods of economic growth, this can cause inflation. Should aggregate demand surpass aggregate supply in an economy, investors will expect high inflation, sometimes prompting central banks (the US Federal Reserve) to implement monetary policy through the increase of their overnight target benchmark rate to combat inflation. This can weigh on equity and bond markets, though it often boosts the domestic currency due to the attractiveness of higher yield. Fluctuations in economic growth, therefore, can cause variations in currency prices. A performing economy may see its currency appreciate, potentially impacting the returns of international investments for domestic investors as the domestic currency can now effectively buy more of the foreign currency. 

Final Words

Ultimately, investors should consider economic growth as one piece of the puzzle when making investment decisions. A comprehensive analysis that includes other relevant factors is crucial for informed and successful investing. It's also worth noting that there are differing opinions on the importance of economic growth. Some argue that focusing on sustainable practices and income inequality matters more than GDP figures.