You don’t have to be Warren Buffet to understand that a good economy is good for investing. In essence, it’s pretty straightforward: A “good” economy bodes well for businesses. And when a company’s business is doing well, investments in that company are also likely to do well. But what is a good economy?
Generally, a good economy is one that produces more goods and services each year. That is, a country with increasing economic activity has a growing economy, which likely creates opportunities for businesses to grow. These then hire more workers, and those workers will demand more goods and services, which will in turn grow the economy, and . . . you get the point.
Although economic activity happens every day, it’s not easy to understand what constitutes “economic activity” in an everyday context. Gross Domestic Product is the most common way to measure economic activity: it equals the value of all goods produced and services provided in a country. The U.S. economy is the largest in the world, and as of 2017 it had a GDP of $19 trillion. Gross Domestic Product can be broken down in into four categories:
GDP = Consumer Spending + Business Investment + Government Spending + Net Exports
- Consumer Spending: Quite simply, this is “people buying stuff” and paying for services. This category reflects how much we spend on a wide variety of things, from groceries to healthcare. Ultimately, every dollar you spend as a consumer is counted here. In fact, consumer spending is the lifeblood of the U.S. economy. A whopping 70% of GDP is generated by the consumer. For comparison, the other advanced economies of the world generate only 55% of their GDP, on average, from consumer spending. And in some countries, consumers generate less than 30% of their country’s GDP.
- Business Investment: This is the business counterpart to consumer spending — think of it as “businesses buying stuff.” When companies spend money to grow their business — such as buying new equipment, starting a new construction project, and even purchasing inventory for later sale — it grows the economy. Business investment makes up about 18% of GDP. An important sub-category of business investment is residential investment, which is basically money spent to build new homes. We follow changes in residential investment very closely as it has proved itself to be a great leading indicator of the direction the economy is headed.
- Government Spending: It’s tempting to think of the economy as purely the goods and services provided by companies, but in reality, government spending makes up at sizable chunk, roughly 17%, of GDP. Our government spends money on things ranging from Medicare to fighter jets, and it all contributes to our economy. However, excessive spending can lead to more government debt, which can later restrain economic growth.
- Net Exports (exports minus imports): This category represents the effect of international trade on GDP. Exports are essentially “stuff we sell to other countries,” and the more we export the more the GDP grows. On the other hand, imports are “stuff we buy from other countries.” Dollars spent on imports do not stay in the U.S. economy, so imports do not have an impact on GDP. However, money spent on imports is measured within one of the other categories (consumer spending, business investment, or government spending), so to erase the effects of imports on GDP, we subtract them here. Overall, the U.S. spends more on imports than it receives from exports, so net exports are negative and reduce GDP by 5%.
Together, the value of all these transactions equal GDP. When this number grows, it means the economy has grown, but remember that growth is not always spread evenly. For example, we could experience strong growth in retail sales (consumer spending), but also decreasing oil exports (net exports). Gross Domestic Product would grow, but in this scenario it’s likely that retail stores did better than oil companies. And you better believe that the stock prices of those companies would react accordingly.
Maneuvering through the web of economic data, like GDP, is not a simple task. But because the constantly shifting economic landscape has a strong impact on investment performance, the BCWM Portfolio Management team considers economic research to be an essential part of the investment process.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.