I’m quite behind on my annual quota for Lessons, so I figured having a nice round superficial number of 40 posts by year end will suffice.
Venturing off from Lesson 39, market trends over the long term are affected by changes in the economy, specifically GDP. GDP trends define where and when a recession is happening, or when an economic boom cycle is beginning. As mentioned before, a recession is defined as a decline in a country’s GDP for two consecutive quarters. Let’s dive into the details of GDP and what comprises it, what drives the direction of it, and what it means for macro economies and for your financial planning.
GDP (Gross Domestic Product) is a measure of the health of a country’s economy. It measures the value of all goods and services produced over a period of time. GDP is measured at a macroeconomic level, as well as at an individual sector level (i.e. utilities, transportation, manufacturing). GDP is comprised of four main components:
1) Personal consumption
2) Net exports
3) Private and public investment
4) Government spending
Any change in one of these factors can tilt the scale in terms of which direction GDP is trending month over month.
Below in Figure 1 is the Canadian GDP levels (in billion $US) since 2008. The Canadian GDP makes up roughly 2.7% of the global economy (Trading Economics).
Figure 1: Canadian Historical GDP (in Billions $US)
Personal Consumption
High levels of personal consumption typically means money is cycling through the economy at a faster rate, putting upward pressure on inflation (see Lesson 22 The Cycle of Money).
Net Exports
An increase in net exports means that a country is simply exporting more goods than they are importing, which indicates higher levels of industrial production over current consumption levels for imported goods. This drives more trade activity which means more money flowing into an economy in exchange for more goods flowing out. Increasing net exports also point to higher outside demand for domestic goods, which not only puts upward pressure on inflation, but domestic currency valuation as well. To illustrate this more clearly, consider the example mentioned in lesson 10:
“If Canada is exporting more crude oil to the US than it is importing (and this gap between exports and imports is growing), the US will be buying more oil from Canada than Canada is buying from the US. That extra bit of exports over imports for Canada will see the US having to buy more Canadian currency in order to buy the oil from Canada compared to the amount of US dollars the Canada is buying to import US oil.”
Private and Public Investment
An increase in corporate investment from either local or foreign investors into the local economy means more capital flowing into the market. More investment means increased funds available for capital expenditures in both the public and private sector.
Government Spending
Increasing investment from outside sources into the local economy usually means additional corporate tax revenues, which also means that government spending can increase without the need to increase leverage, increase cost of capital, or to request additional credit facility availability.
Money truly moves within a cycle, and the faster this cycle moves, the healthier an economy will be, and the more stable GDP will be over each measured period.
However, with any economic cycle, there comes times of recession where corporate earnings growth slows due to fiscal and monetary policy, inflation decreases because of slowed consumer spending, investment in the local economy decreases from both domestic and outside sources, and a slowdown in industrial production and exported goods.
GDP provides meaningful signals of where an economy is trending towards. Having cash available during a recession to funnel into equities near a market bottom is always ideal, however difficult to time. Cash is king, and having a portion of one’s portfolio in cash can help one take advantage of investing in companies that have had their valuations cut severely over the course of a market decline. This is especially important for patient long term investors, who ignore market fluctuations and buy into the markets regardless of recent trends. This will be the case anyway if you have your money managed by a financial institution, so no need to worry or panic if a recession seems imminent!
If an investor owns a large bond portfolio, being nimble on adjusting the duration of the bond portfolio (i.e. shortening or lengthening the average time to maturity of bonds depending on the direction of interest rates) can help optimize an investor’s ability to remain liquid and reinvest cash during recessionary times. In other words, if interest rates are going up, this devalues bonds so you want a shorter time to maturity to quickly reinvest that cash at higher interest rates when the old bond matures. If rates are going down, this increases values of bonds, in which an investor would want to hold their bonds for longer and avoid having to reinvest money at a lower interest rate when the bonds become due.
For individuals who are more hands on, recognizing signals of forward movements of the economy like GDP trends can help dictate how much of risk free and risky assets comprise one’s portfolio
To sound exactly like a broken record, it’s important to be aware of current global macroeconomic conditions to help optimize your investment decisions and when to add cash to one’s portfolio, or to shift weightings between risky and risk free assets. It’s your money and you worked hard for it, so regardless of your involvement with the long term management of your savings and investments, you should be in tune to how macroeconomic factors could potentially impact your money, and ultimately your retirement nest egg.