How do you count an economy? Award-winning financial writer Cherry Reynard examines the well-worn volumes of GDP data and looks into several other ways to determine growth, from investor temper to fertility…
GDP, or gross domestic product, has long been used as a by-word for economic strength. President Trump boasted that he could achieve 4% GDP growth in his election campaign, while the UK’s weakening GDP figures have been seen as a sign of Brexit’s negative weighing on the economy. But is GDP such a good barometer of a country’s economic health? There is an argument that it only gives a highly selective insight.
GDP is described by the International Monetary Fund (IMF) as a measure of “the monetary value of final goods and services—that is, those that are bought by the final user—produced in a country in a given period of time”. It has long been argued that it is a poor reflection of the actual strength of the economy, at least in the UK. Notably, Richard Jeffrey, former chief economist at Cazenove Capital, has suggested it fails to pick up what is happening on the fringes of the economy, in areas such as technology where businesses are being created rapidly, employing people and making capital investments.
In a recent blog, he pointed out that making an allowance in macro-economic data for the production and consumption of internet-based products is extremely difficult: “Consumers spend considerable leisure time consuming ‘free’ internet-based products e.g. Twitter and Facebook. While statisticians can include the amounts spent on mobile phones, tablets and computers in consumer spending, it is very difficult to impute the benefit that people get from the consumption of social media products.”
He is not the first to suggest that GDP is an inadequate reflection of the economy. Dr. Eamonn Butler at the Adam Smith Institute said that it also fails to measure qualitative improvements in goods and services: “All sorts of stuff is simply getting better. Kitchen appliances do what all those servants slaved on, and have become cheaper and cheaper and cheaper. Our homes and workplaces are cleaner, healthier and more environmentally friendly than those of 1836—or even those of 1936—but none of that gain in value is measured by the GDP figures.”
GDP is generally poor at measuring intangible investment and its impact on national accounts. A recent book, Capitalism without Capital, The Rise of the Intangible Economy, by Jonathan Haskel & Stian Westlake, argues that an intangibles-rich economy should be measured in fundamentally different ways from one based on tangibles. The rise of intangible investment is, they argue, “an underappreciated cause of phenomena from economic inequality to stagnating productivity”.
The inadequacy of GDP as a tool is, to some extent, evident from the significant revisions seen to GDP growth. The most recent example is Japan, where estimates for fourth quarter GDP growth were recently revised to 1.6% against a preliminary reading of a 0.5% expansion – essentially representing a change in the margin of growth of 200%. Again, the problem seemed to be based on technology: There was an upward revision of capital expenditure and inventory data because the original figures did not fully reflect investment in information and communications such as smartphone and production machinery including robots and other labour-saving technology.
This suggests that as technology becomes a greater part of the economic life of a country, GDP may become a less accurate reflection of an economy. Gavin Haynes, investment director at Whitechurch Securities, admits his team only use it selectively in their asset allocation: “Part of the problem is that the information is available to everyone and therefore will already be in the price of assets. More importantly, it is historical. We pay more attention to the direction of GDP figures – is it improving? It is only one measure of the health of an economy.”
So, for many economists, investing in the prospect of future economic health is as important as the current well-being of an economy. In terms of finding metrics with greater predictive qualities, investors will need to look at leading rather than lagging indicators. Purchasing managers’ indices (PMI) rates tend to be among the most reliable and widely used. PMIs aggregate new orders, inventory levels, production, supplier deliveries and the employment environment to come up with a figure that can be used to judge business conditions. They tend to be taken as a measure of corporate confidence, with figures above 50 suggesting expansion.
“We look at PMI data in lots of different ways,” says Anthony Willis, investment manager at BMO Global Asset Management. “We have built out own composite index, which gives a better picture. For example, manufacturing is only 12% of the UK economy, so it’s important not to overstate its importance relative to services, which is far larger.” It has alerted his team to the fact that there is some minor weakness in Eurozone data, for example, which may be important to watch for its future positioning.
He also looks at government spending. In the US, for example, he believes the tax cuts are a tailwind for growth in the short-term, potentially extending the current cycle (while also creating problems in the longer-term). He will also look at how US companies are spending their windfall. Is it going on higher wages – potentially good for the economy – or just on share buybacks – less good?
Taking stock – but of what?
A less reliable barometer is the stock market. For example, while stock market crashes have generally anticipated a recession rather than followed it, not every crash has been accompanied a recession, so it’s not particularly reliable as an indicator. Economist Paul Samuelson famously said that the stock market has predicted nine of the past five recessions.
The stock market reflects investors’ confidence in the future earnings of the companies listed on it. That said, investor confidence can be unreliable and prone to panic. Equally, it can be shored up by, say, the intervention by central banks. This is what happened after the crash in 1987, where central banks stepped in to prevent wider contagion in the economy.
The bond market has a better track record as a predictor of recessions. David Roberts, head of global fixed income at Liontrust, points out that US bond yields have typically inverted between six and nine months before the start of a recession. This makes intuitive sense: Short dated bonds are sensitive to short-term changes in the Federal Funds rate. At the same time, investors start to worry that higher rates will choke off growth and inflation. They seek out long-dated bonds to protect themselves against the risk of recession. Longer-dated bonds also drop because investors foresee interest rates having to fall again in future as economic weakness bites.
There are also more technical reasons: financial institutions tend to borrow at the short end and lend at the long end. When it costs them as much to borrow as it does to lend, they are likely to reduce the supply of credit because it is less profitable for them. This also contributes to weakening economic growth.
A combination of other leading indicators may also give clues to economic health. The level of new business start-ups, for example, or retail sales can all provide some insight into potential economic growth. Building permits can also be an indicator of confidence. Other economists have made the case for divorce rates and even the rate of women becoming pregnant as indicators of economic strength. A recent book Is Fertility a Leading Economic Indicator? by Daniel Hungerman, Kasey Buckles and Steven Lugauer suggests that pregnancy rates begin to fall several months before the start of a recession as people become more nervous about their job security.
There is no perfect barometer of economic health. This in itself highlights a key problem with assessing value in financial assets where statistics can be used as short-hand, with only a partial understanding of their real significance. It also makes the case for holding part of a portfolio in ‘real’ assets, which have a tangible value beyond the competing views of investors.
Cherry Reynard is an award winning financial journalist, who has written for the Financial Times, Forbes, Investors Chronicle, The Telegraph and Money Observer