Why Does GDP Growth Matter?

The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time. Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.

Today, we offer our thoughts on what we consider table stakes in trading markets and a precise understanding of why Growth markets to investors.

We think that GDP Growth is particularly important to macro investors. However, the specific measure and definition of growth are less important than the conceptual understanding of why growth matters to macro assets, i.e., stocks, bonds, and commodities, constantly experience price changes to reflect ongoing changes in expectations for their demand, supply, and cash flows. At an individual level, each of these assets has extremely specific drivers, such as earnings announcements (stocks), interest rate policy (bonds), inventory reports (commodities), etc., all of which impact the price for a specific asset. To an investor unaware of the impact of macro conditions, each of these instances is highly precise, with one instance having little to do with another. Said differently, with a zoomed-in perspective, most market price changes look idiosyncratic.

However, what this zoomed-in perspective often misses is that what often seems idiosyncratic is, in fact, systemic. A company may not have missed earnings solely due to mismanagement but rather because the demand for the products of the entire sector has decreased; the interest rate on a bond did not rise because the probability of default rose but rather because the government raised interest rates, and perhaps orange juice demand didn’t rise because of a lack of oranges but rather because consumers now have increasing incomes.

In essence, what a macroeconomic approach seeks to do is to zoom out to smooth out the noise coming from the idiosyncrasies of an individual asset, and aggregate the signal for entire asset classes.

This macro-perspective allows you to capture the factors that are not just driving one asset but all of them. What that means for investors is twofold: you can have a more diversified set of positions by focusing on macro, and you can spend most of your time focusing on the principal driver of assets rather than a litany of less important drivers. The combination of these creates tremendous portfolio benefits, as macro drivers account for the majority of variance in asset markets. Focusing on whether macro conditions are supportive or detrimental will deliver the best portfolio improvements to most investors by reducing idiosyncratic noise and increasing systemic signal.

The most important macro driver of asset markets over time is economic growth.

More rigorously, we define growth as the mosaic painted by income, spending, production, and employment measures. We find this mosaic best captured by GDP growth. GDP growth is the widest definition of economic growth across countries, accounting for domestic spending by households, businesses (profit & non-profit), governments, and foreigners. The other side of the GDP accounts is GDI, which accounts for the incomes that finance the ongoing spending recorded in GDP. These two measures of activity are two sides of the same coin and are conceptually equal at all times in an economy. If we adjust these measures for inflation, we obtain total output, i.e., real GDP & GDI. Finally, central to all of this output is the labor market. Employees are at the center of the circular relationship between income & spending. Without a growing labor market, incomes can’t grow much, which, by definition, weighs on spending. This centrality of labor markets makes output and incomes inextricably linked.

A holistic approach to macro tracks all of these variables, but it is also important to recognize that due to their interlinked and circular nature, GDP does an excellent job of capturing the dynamics happening across them. Crucially, this discussion is not about a specific measurement provided in the NIPA accounts, released with a one-quarter lag. This discussion pertains to the concept of GDP as a comprehensive measure of economic activity. The timeliness of this measure can be employed through nowcasting models, which we use extensively.

We can now turn to how these GDP conditions flow to asset prices. All changes in asset prices are a function of changes in expectations for the demand, supply, and cash flows associated with the asset. GDP impacts these expectations for each asset differently. The headline GDP number rarely matters to any asset, but rather the implications for its specific drivers. We examine them individually.

Stocks are the most sensitive to real GDP conditions. As discussed, GDP measures the total amount of spending in the economy. This spending forms the basis for the total potential revenues for corporations. After accounting for costs and reinvestment, corporations may redistribute earnings via dividends or corporate buybacks. As such, during periods of rising revenues, the likelihood of higher revenues, higher profitability, and higher shareholder returns all increase, particularly if these increases are more than what’s priced into markets. Furthermore, increasing GDP conditions create a larger savings pool for households and businesses to invest in a given stock of existing equities, potentiating gains.

Now, we must recognize that these revenues, profits, and shareholder pay-outs are nominal. However, a large part of whether businesses are generating significant profits or not depends on whether they are seeing sales increase at a pace faster than their input costs increase. Thus, it is rare for businesses to increase their revenues durably solely based upon price increases in the macroeconomy because costs tend to be commensurate with the rice in sales prices. As such, the best outcomes for equities come from rising sales and rising output, which translates to rising profits. The converse is also true, where falling output, sales, and profits hurt equities dramatically. Avoiding these periods is a key focus for macroeconomic conditions.

Bonds are indirectly affected by GDP conditions. Unlike stocks, where cash flow from GDP to earnings directly determines price outcomes, bonds are not directly affected by GDP conditions. But rather, bond prices are predominantly driven by expectations of monetary policy by the Federal Reserve. The Fed seeks to protect the economy from outlier macroeconomic events, particularly, excessive inflation or deflation, and extreme weakness in labor markets. The Fed moves monetary policy based on evolving macroeconomic data, which determines the majority of bond yields. As such, bond markets are highly responsive to what growth conditions mean for labor and inflation, and the Fed’s reaction function to these conditions.

Furthermore, bonds are a fixed-income asset, and changes in the economy make this fixed rate of income look more or less attractive in comparison. During a rising nominal GDP environment, where output is rising and equities are seeing rising expected payback to shareholders, the value of a fixed-income payment begins to look less attractive. During periods of recessionary GDP, the fixed cash flows provided by bonds begin to look far more attractive. As such, while bond markets do not receive a direct compensation or cost from GDP, the Fed’s reaction function to growth conditions and inflationary pressures makes bonds move countercyclical (better when the economy is weaker, and worse when the economy is stronger).

Commodities depend on nominal spending. Unlike equities and bonds, commodities have no cash flows associated with them. As such, the primary linkage for commodities to the economic cycle is through the simplest and most fundamental relationship: demand and supply. The productive capacity to make commodities is a relatively slow-moving component of the economy, i.e. it takes a long time to move supply upwards. However, the demand for commodities can be quite flexible, because companies and individuals and borrowing money to amplify their purchases nearly instantaneously. As such, commodity prices are highly sensitive to the ongoing changes in nominal GDP conditions.

Particularly, commodities are more responsive to the rate of change of nominal growth conditions than the ongoing level of growth. Nominal growth accelerations can only be met with a limited amount of commodity production increases, after which point there becomes a significant demand and supply mismatch. As such, a significant amount of accelerations and declarations in nominal GDP result in strong and persistent commodity price pressures to the upside and downside.

Given the centrality of macro conditions to portfolio outcomes, and the nuanced linkages of GDP to all macro assets, we think that strong Growth conditions should be prioritized by all investors. Consistent with these principles, we have built our systematic process around having both a rigorous understanding of growth conditions, but also it’s nuanced transmission mechanism to various asset markets.