I'm not an economist. Nor am I planning to be one. But I am studying "Macro" as part of a Bachelor's Degree I'm taking in Business Management, and invariably, if you like and invest the stock market, even if you're not studying Macro like I am, it's fundamental to understand at least the basics of how a country's economy and government's policies can influence stock market moves, so as to better your decision making on your equity investments. Macroeconomics study the working of an economy as a whole (all households, all firms, all markets). Some of the macro variables/indicators are GPD, inflation, central bank interest rates, or the unemployment rate. In this series we will overview these 4 variables, starting with GDP.
Gross Domestic Product is the standard measure of the value added created through the production of goods and services in a country during a certain period. It's usually measured in timeframes of 1 year. To summarize it in practical and investment-oriented terms, it's an indicator by which we can measure the economic growth/contraction from one year to the other, by watching GDP values over different timeframes. There are several different approaches by which we can measure GDP, like the Production approach, or the Expenditure approach. Each tackles economic activity from a different angle, and as such, GPD is defined by whatever approach we decide to have. It's important to note that's it's inherently hard to measure economic activity to pinpoint accuracy. GDP measures don't account for certain activities, like the transaction of used goods, and goods sold in the black market, or tax evasion.
There are several important details to consider with Macroeconomic variables like GDP. Inaccurate/wrong measurements of macroeconomic aggregates may lead to dangerous or perverse policy measures, or private agents may make the wrong decisions. Also, the state of the economy and our well-being may give a misleading view of the true state we are living in. In fact, in economics, there may be very few things more important than measuring correctly the main macroeconomic aggregates.
Real GDP vs Potential GDP
Potential GDP refers to the level or measure of output that an economy can produce at a constant inflation rate. Potential output is estimated by estimating potential gross domestic product. Capital accumulation, or stock, labor growth, market efficiency, liquidity, and government policies influence this measure. To give it some context, it's a long term trend around which the economy oscillates.
Real GDP is, to simplify it, the measure of the value of economic output adjusted for price changes, unlike the P-GDP which does not account for this part. It's also the GDP value that's statistically registered by the appropriate entities. With both definitions in place, and by imposing both data and charts on top of each other, like the one I depicted above, we can understand in a basic way what's called as boom or bust cycles.
Boom VS Bust Cycles
With knowledge of both Real GDP and Potential GDP, we can understand how the economy is perfoming versus how it was expected to have performed. We can use R-GDP deviations from P-GDP. If the economy is growing at a faster pace that its potential, it's in a boom cycle. If the GDP/economy is shrinking, it's in a bust cycle.
The boom cycle is measured from the bottom of the R-GDP to the top of that cycle, above the P-GDP. The bust cycle is measured from the top of the R-GDP to the bottom of its cycle, usually below the P-GDP. The difference between the Real GDP value and the Potential GDP value is called the output gap. This is measured in percentage points.
Some conclusions and tips
With the basics of GDP in place, we can start to compare some charts to better our decision making in the stock market. We can compare Real and Potential GDPs from several countries, to understand whether economic cycles are global, or localized to a region or a country and, if global, which countries have "performed" better or worse within that cycle, like in the example shown above. We can see that in the first decade of the 80s, Portugal experienced an economic bust that was much more severe than the UK and France.
Reducing the stock market to its bare minimum, and speaking in theory, investments in French or British companies during that time would have had a better chance of performing above investments in Portuguese companies, as both the UK and France experienced a less dramatic slowdown of their economy during the same time and, as such, their companies and businesses as a whole, too. If Europe enters a bust cycle while Asia enters a boom cycle, it would probably be better to invest in companies in Asia, rather than European businesses.
This should cover the most basic part of GDP and how it can help you better understand stock markets moves. On part 2, we will continue explaining other macroeconomic aggregates.