Gross Domestic Product, or GDP, is a measurement of economic output. It’s the total value of all the finished goods and services produced within a country, region, or industry during a specified time, usually a year or a quarter. GDP helps measure economic health and growth.
What is GDP?
A simple way to define Gross Domestic Product is to break down the three words making up the term:
- Gross is the total market value of how much goods and services cost in the marketplace.
- Domestic refers to the country or home of the economic output.
- Products are the goods (things made) and services (actions provided) purchased by end-users.
Put together, GDP is the total market value of all the goods and services produced within a country’s borders during a year.
Economists calculate GDP using four inputs:
- Personal Consumption Expenditures: Total consumer spending on goods and services such as food, entertainment, and medical bills.
- Investment: Business spending on fixed assets such as land, buildings, and equipment. This category also includes unsold business inventory and homes purchased by consumers.
- Government Spending: The money spent by federal, state, and local governments on goods and services such as education, infrastructure, and defence.
- Net Exports: The value of exports minus imports.
The formula for calculating GDP uses the underlined letters from above:
C + I + G + NX = GDP
Why is GDP important?
GDP is a crucial measure of economic health. Rising GDP shows that an economy is expanding. It implies that consumers aren’t worried about their jobs, so they spend more money on goods and services. Businesses, meanwhile, continue to expand because they see opportunities to increase profits.
However, slowing GDP growth or a decline can suggest that the economy is heading toward or has fallen into a recession. That can cause consumers to reduce spending as they worry about job security. It can also cause businesses to reduce their investment levels.
Public policymakers, from legislators to central bankers, use GDP as a guide to determine policy moves. For example, the government could pass legislation to spur economic growth if GDP shows that the economy is in a downturn. Likewise, the Bank of England will look to GDP as one of many inputs of economic health when determining whether to reduce or increase the Bank Rate.
How investors can use GDP
The economy moves in a four-part cycle:
- Expansion: A period of sustained GDP growth.
- Peak: A time of slowing GDP growth.
- Contraction or recession: A time of negative GDP growth.
- Trough: A brief period where GDP stops declining and starts to recover.
Many industries are susceptible to changes in economic or GDP growth. For example, consumer spending on items such as airline tickets, hotel stays, restaurants, cars, clothing, and consumer products rises when the economy expands and falls when it’s contracting. Companies involved in economically sensitive industries usually see their earnings and stock prices rise and fall with the economic cycle. Investors call economically sensitive companies cyclical stocks.
Given their nature, investors can use GDP as their guide for when to buy and sell cyclical stocks. The best time to buy cyclical stocks is during the trough phase and the early stages of an expansion. Investors should avoid or sell cyclical stocks when GDP growth is slowing. Investors can use GDP to maximise returns and minimise losses in cyclical stocks.
How fast is UK GDP growing?
The Office for National Statistics (ONS) releases its estimate for UK GDP every month. The ONS’s latest release came in mid-April 2023, covering GDP estimates for the month of February. The report showed that GDP grew by 0.4% – slightly faster compared to a year ago.
The GDP report hints that the UK economy is improving and could potentially narrowly avoid a recession. Nevertheless, investors should still position their portfolios for a potential downturn. Possible moves could include reducing their exposure to cyclical stocks and increasing their investment in more recession-proof companies that aren’t as reliant on the economy to drive their growth.