What is Economic Growth and Why is it So Important?
Top news headlines are often dominated by the release of gross domestic product (GDP) figures and for good reason. The GDP release attracts a lot of attention from traders and market participants because of its signaling effect and ability to move financial markets.
This article explores the concept of ‘growth’ from an economic perspective and why it is beneficial for traders to have a solid understanding of the subject.
What is GDP Growth and How is it Reported?
When news outlets or financial publications refer to ‘growth’ they generally mean gross domestic product or GDP.
GDP measures the value of goods and services produced by a country in a given year and serves as an indication of economic health of that country. Essentially, it’s an objective measure of improving or worsening economic conditions in a particular country over time.
How is GDP Reported?
GDP has four main readings, one per quarter, often denoted as Q1, Q2, Q3 and Q4; but you may notice that GDP figures are reported every month. This is because GDP is a lagging economic indicator, meaning that there is a lag period before the data is collected, analyzed and adjusted to account for seasonal influences. Lagging economic indicators are not to be confused with lagging technical indicators.
GDP figures are mainly reported as a quarter on quarter figure (QoQ) or year on year (YoY). The below image shows the percentage change in real GDP* (QoQ):
*Real GDP provides a more accurate indication of production/output as it removes the influence of higher prices on the value of aggregated goods and services in the economy
There are three reported figures for each quarter:
- The preliminary/advance figure
- The second estimate and
- The final GDP figure.
The preliminary/advance figure tends to have the biggest impact from a trading point of view as the other two figures generally involve small refinements to the initial figure. The component factors that make up GDP can often be observed and aggregated ahead of the released figure, meaning GDP is less likely to provide a shock to the market than other data releases such as Non-farm Payrolls (NFP).
However, do keep in mind that for major economies an estimated GDP growth figure that differs from the actual by 0.3 or 0.2 percentage points can translate into billions of dollars -which may attract varying opinions of the state of the economy and result in elevated volatility after the release.
For more information on these releases, click the drop down arrow next to the event on the DailyFX economic calendar
GDP Growth and the Signaling Effect
The state of the economy is watched very closely by governments and central banks. When the economic growth (GDP) is stagnant or the economy is technically in a recession, central bank policy shifts and becomes more ‘accommodative,’ providing liquidity and lowering interest rates; while increased government spending often follows suit. In economic booms central bankers look to reign in overheating economies and monetary policy becomes more ‘contractionary’ in nature – raising interest rates, while governments often reduce spending.
Longer-term macro traders are able to analyze whether an economy is in a boom, recession or transitionary phase when planning trade set ups. Currencies linked to central banks that are ‘hawkish’ tend to appreciate at the start of an interest rate hiking cycle; while currencies linked to central banks that are ‘dovish’ tend to depreciate at the start of an interest rate cutting cycle.
For equities, lower future interest rates will make it easier for individuals and institutions to access credit at low rates which can be used to invest in the stock market. Additionally, lower interest rates translate into lower discount rates applied to future company cash flows to arrive at a higher valuation for shares in general.
For an in-depth understanding of the stock market, read through our comprehensive Understanding the Stock Market education section
Furthermore, traders are often able to pick up on clues on the direction of future monetary policy from the tone and language used by the heads of various central banks in their press conferences. Press conferences follow after an interest rate decision has been released.
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GDP: Components of Growth
From an economic point of view, the main components of growth can be listed under the following broad categories:
- Government spending
- Net exports
Output (GDP) = Consumption + Investment + Government spending + Net Exports
Consumption is the everyday exchange of money for goods and services such as buying groceries or paying your internet service provider. Investment refers to private local investment or capital expenditure, for example businesses will reinvest in the business to increase productivity and boost employment levels.
Governments spend money on infrastructure, equipment and salaries of government employees and this expenditure can look significant in times when general spending and business investment decline. Net exports is the result of taking total value of exports and subtracting the total value of imports and is the result of international trade.
Leading Economic Indicators of Growth
GDP growth is not the only indication of the state of an economy. While GDP is inherently lagging in nature traders can consider a whole host of leading economic indicators that can provide insight into the condition of different sectors of the economy before the GDP data is even released.
The data releases provided below also shed some light on underlying economic environment before GDP data is released:
- New building permits – This measures the change in the number of new building permits issued by the government. Building permits are a key indicator of demand in the housing market and the housing market/construction tend to move closely with the underlying state of the economy.
- Consumer credit – This figure has strong ties to consumer spending and confidence. Rising debt levels are usually indicative of economic strength as banks feel comfortable issuing approving lines of credit. On the other hand consumers feel financially stable enough to make the monthly repayments.
- Retail sales – Considered a primary gauge of consumer spending, which accounts for a sizeable portion of overall economic activity
- Consumer confidence – This measures the level of consumer confidence with respect to economic activity. It is a leading indicator as it can predict consumer spending, which plays a major role in overall economic activity. Higher readings point to higher consumer optimism.
- ISM Manufacturing/services PMI – Purchasing managers in any company hold the most current and relevant insight into their company’s view of the economy and therefore their sentiment of current economic conditions are of great value. A value above 50 indicates optimism while values below 50 are viewed as pessimistic.
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NFP and Forex: What is NFP and How to Trade it
Read our article on how Interest rates affect Forex