Summary: Politics, government spending, inflation and much more are all impacted by the performace of a national economy. Here we attempt to explain some of these relationships, and their impact on the stock market. To do this, we simply ask, "What is economic growth?"
Television news broadcasts often tell us about the performance of the economy. It is a vital piece of information in the way in which our part of the world operates. However, in the modern world, it is a collection of numbers rather than just one.
Things like property prices, rates of inflation and consumer spending all have an important place in this puzzle. The central piece of this puzzle though is gross domestic product (GDP) which is a measure of the output of an economy. For ease, it is easy to think of output as being the finished goods or services. Therefore, rather than the parts of a car, it is easier to think of the car itself.
Needless to say, in the globalised world in which we live, such numbers are coming under increasing pressure as to their meaning and relevance. The days in which all the parts of a car were made within a short distance of the factory that assembled the car are long gone.
The job of GDP is to try and combine all this economic
'activity' into one number that can be followed. Then, over time, trends
can be seen as to whether this number rises or falls, and thus, whether
an economy is increasing or decreasing in size. While GDP is measured monthly, the annual growth figure is generally more recognised. Whether an economy grows or shrinks by 0.1% in a given month will be meaningless to most people, but 1.5% per year is a number that people can understand a little better.
This increase in GDP, reflects economic growth.
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This definition is - of course - meant to be simplistic. Understanding
GDP can be increadibly complicated (and we are trying to make this page
readable to people that do not have a macroeconomic background).
For example, an economy may be able to generate more finished products without the need of additional resources. This may mean that processes have been made more efficient or perhaps that people are working harder. These are known as productivity gains.
However increases may be obtained, this extra output will normally lead to other things. These other things may include pay rises for the workforce (an increase in expenditure), additional money being spent on research and development for new products and a greater amount of money (hopefully in the form of profits) on the balance sheets of companies.
It is this increase in corporate profits that can then lead into higher valuations of companies with a stock market listing and on to a rising stock market. As more and more companies are in possession of more and more retained profits, the cumulative impact ought to lead to vastly increased stock market valuations.
Get to work
There are other very positive side benefits of a growing economy. One very important one is that more jobs will be created. Over time, this should cause unemployment fall. Very few countries are able to attain a state of (what is known as) full employment, but falling numbers of unemployed people is a very good thing. As more people have jobs they will pay more taxes and there will be less social welfare benefits to be paid for them. As you might imagine, job growth is very good for the balance sheet of the economy.
More people in work will often lead to greater competition for staff. This is good for the staff, obviously, but not always good for the company stock price. As a general rule, when there is low wage inflation, stock markets tend to rise - sometimes strongly. This is, in large part, because for many companies their highest expense is their cost of staff. If this cost will be stable for some time, this provides room for more revenue to make it to the bottom line in the form of profits.
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How individuals, corporations and governments respond to this increase
in wealth will ultimately influence the type of slowdown that will
eventually occur. All good things - even economic growth - come to an
end sooner or later, though this may take many years to happen.
This
slowdown is more normally called 'negative economic growth', suggesting
that the GDP number is no longer rising. Numbers below 0 are considered
negative. If an economy has two consecutive quarters with negative growth the economy is considered to be in a recession.
There is also the sometimes tricky issue of a 'slowdown in economic growth' to deal with. In some more dynamic (usually emerging or developing economies) growth might be in the high single digits - for example 7% pa. Should that number fall, but still be positive - for example dropping to 5% pa - there is still growth but at a slower rate.
Stock markets and currency markets usually react poorly to such news, despite the fact that the economy is still growing. This is because the market has - wrongly it seems - priced in continuing growth at the higher number. Now that GDP is growing less quickly than previously, assets may be overpriced, causing a correction of some kind.
The growth, bull markets and bubbles of the years between 1990 or so and 2007/8 lead to a rise in borrowing to fund speculation. In an ideal world, we will all use economic growth to repay debts and strengthen our financial positions, so that we will be able to borrow if required during a slowdown. This approach (that is being very poorly paraphrased!!) dates back to the thoughts of John Maynard Keynes - called Keynesian economics - though he applied to governments rather than individuals.
In contrast, many organisations and individuals borrowed heavily, 'investing' (though many were really gambling) that the good times will last. Sooner or later, the crisis of confidence comes and everything collapses around us.
Economics underpins society
In many ways, GDP is also a good guide for the future of an economy. There are many countries in which the ruling politicians and generals use poverty as a means of control. There are many countries in Africa where this is the case.
Typically, as people become wealthier (even if only a little) they choose greater levels of education for their children. This gradually provides economic development as more people are able to perform higher quality work. It is also likely to lead to greater economic efficiency by the workers, freeing up people from most labour intensive work.
Eventually, this development provides a better standard of living for the entire community, leading (hopefully) to greater political and economic security.
A stock market barometer
With regards to investment, the United States economic growth is one of the most important pieces of economic news there is. The USA is such an important driver of the world economy that what happens there has an impact in many other places and ways. If there is poor US economic growth news, the major stock exchanges of the world will almost certainly be negatively impacted.
There are a number of other countries where the economic news is vital to the world, such as China, the UK, Japan, Germany and the EU. Most other nations do not have enough global impact to be of real consequence.
Bad news - depending upon the news - can have an impact on interest rates and inflation numbers, both of which are important to the markets. The easiest way of thinking about this is that the Dow Jones needs business as usual and as few changes and surprises as possible.
To read more pages on related topics, please follow these links:
Understanding Bull And Bear Market Situations
What Is A Bull Market?
Can You Make Easy Money In The Stock Market?