What is GDP
Quick Summary: Gross Domestic Product is a measure of the total value of all goods and services produced by a particular country or region. In the UK this is release by the Office for National Statistics. In the Eurozone it is released by Eurostat. In the US the figure is released by the US Bureau of Economic Analysis. GDP is considered a broad measure of that country’s or region’s economic activity and health. Usually, a rising trend has a positive effect on currency and equity markets, while a falling trend is seen as negative.
What is GDP?
Being the most comprehensive measure of a nation’s economy, understanding the GDP report is a must for traders involved in any financial market. The GDP report is released quarterly and often creates large price movements in the market, especially when the actual number differs from market expectations to a large extent.
In the following lines, we’ll dig deeper into the world of GDP reports, show how they’re calculated, how they can be anticipated, and how traders can take advantage before the report hits the newswire.
GDP: Why Do Traders Care?
Gross Domestic Product (GDP) is the most comprehensive measure of a country’s economic activity. GDP represents the total market value of all finished goods and services, produced within the borders of a country during a specific period of time. It’s the broadest measure of the total economic activity of a country available to economists, traders, and analysts.
The concept of GDP was first conceived in 1937 by Simon Kuznets, an economist at the National Bureau of Economic Research. GDP was soon adopted as the standard reporting framework for national economies worldwide.
In the United States, GDP is reported quarterly by the US Bureau of Economic Analysis and includes data sets on personal income, consumption, national income, and corporate profits. Most of the numbers that form the total GDP are also reported in real terms, i.e. adjusted for inflation and price changes.
Although GDP is reported quarterly, there are also some earlier releases, such as the advance GDP which will be discussed further below. The headline number is the annualised GDP growth, although markets focus on quarterly GDP changes as well.
GDP can be reported using different types of measurements. To fully understand the concept of GDP and apply it to your daily trading, you need to be aware of the differences between the various measurement types.
- Nominal GDP – The nominal GDP represents the raw data that is not adjusted for inflation.
- Real GDP – The real GDP report is the nominal report adjusted for inflation and provides a convenient way to compare GDP reports over a period of time.
- GDP Growth Rate – The GDP growth rate is the change in total GDP, usually over a period of one year, reported in percentage terms.
- GDP per Capita – The GDP per capita report takes into account the differences in the population size of various countries and is simply calculated as the total GDP divided by a country’s population. GDP per capita is quite useful when comparing economic outputs between countries of different sizes.
Types of GDP Releases
Although GDP is released on a quarterly basis, traders and other market participants can get an insight into the previous period’s GDP by looking at the advance and preliminary reports. The advance GDP report is released around two months before the final GDP and thus has the largest impact on the market.
However, bear in mind that the advance GDP is often adjusted by the preliminary and final reports as new data comes in, and is, therefore, the least reliable report of the three.
The preliminary report is released one month after the advance report and one month before the final GDP report. The final GDP report is the latest report with the least market impact but the most reliable of the three.
How to Anticipate GDP Growth?
As a quarterly release, markets usually price in most of the movements and data before the GDP report sees the light of day. It’s the most comprehensive report that measures the total economic activity, and as such can be successfully anticipated by other, more timely economic indicators, such as stock indices, retail sales, and personal consumption, and housing starts.
Since GDP takes into account corporate profits, which in turn are reflected by the stock market, stock indices can be used to anticipate future GDP growth. Rising stock prices and overall consumer confidence in the market tend to have a positive impact on GDP while falling stock prices tend to lead to a lower GDP. To anticipate the GDP report for your country, you can use the S&P 500 index for the United States, the FTSE 250 for the United Kingdom, the DAX for Germany, and the Nikkei 225 for Japan, to name a few.
Retail sales and personal consumption is a key input for the GDP report and have a significant impact on its value. It’s estimated that personal consumption, such as buying groceries or washing a car, accounts for roughly two-thirds of the total economic output in developed economies such as the United States and the United Kingdom.
Following the personal consumption and monthly retail sales numbers can provide a useful insight into the trend of a country’s GDP. The following chart shows how declines in consumer expenditure signalled each of the six recessions in the United States from 1963 to 2003. Traditionally, big-ticket items, such as cars and expensive durable goods are the first to be removed from shopping lists, so it pays to follow those reports when anticipating future economic growth.
How is GDP Calculated?
There are three main ways to determine GDP:
- The expenditure approach
- The output (or production) approach
- The income approach
If correctly calculated, all three approaches should return the same numbers. Here’re the main differences between those three approaches.
Expenditure approach – As its name suggests, the expenditure approach measures GDP by calculating expenditures of various economic groups, such as consumers, governments, corporate investments, exporters, and importers. The US GDP is measured and reported using the expenditure approach. The expenditure approach uses the following formula for calculation: GDP = C + G + I + (X-M), where C = consumption, G = government spending, I = investment, and (X-M) = exports – imports, i.e. trade balance.
Consumption or private expenditure (C), as noted earlier, accounts for the largest part of a country’s GDP. High consumer confidence can have a large impact on future economic spending, which is why following consumer confidence and sentiment indicators should be part of your daily trading routine.
Government spending is an important part of overall economic activity and includes government payrolls, infrastructure investments, etc. Government spending actually represents government budget deficits and surpluses. As a rule of thumb, the higher the budget deficit, the higher the government spending, and vice versa.
Investments (I) include private domestic investments, such as corporate investments in business activity and machinery buying. Investments have a direct impact on future employment, and indirectly on consumer confidence and private consumption (employed people are more likely to spend their income on expensive items, for example.)
Finally, the trade balance (X – M) affects GDP positively in case of a trade surplus, and negatively in the case of a trade deficit.
Output approach – Instead of measuring expenditures that run economic activity, the output approach measures the total value of economic output. In this approach, the costs of intermediate goods required in the economic process are deducted from the total number since those goods are already priced into the final goods.
Income approach – The income approach measures GDP from the income side and includes income earned by all factors of production, such as earned rents, labour wages, and corporate profits.
GDP, GNP, GNI – What’s the Difference?
Besides the gross domestic product (GDP), there are also other ways to measure a nation’s economic output. The two most popular are GNP (Gross National Product), and GNI (Gross National Income).
While GDP measures the total market value of all goods and services produced within a country’s borders in a specific time period, GNP measures the total value of goods and services produced by a native or company, including those located outside a country’s border. In addition, the GNP excludes production by foreigners, even those located within a country’s border. The GNP uses the output approach in its calculation.
Alternatively, the gross national income (GNI) measures the total income earned by a country’s citizens, regardless of the place of production. Unlike the GNP, the GNI uses an income approach is often referred to as the modern version of the GNP. In addition, as the global economy becomes heavily interconnected, the GNI offers a better insight into a country’s economic activity and growth than the GDP or GNP.
GDP and Purchasing Power Parity
To make GDPs of various countries comparable to each other, economists use the purchasing power parity (PPP) to derive a number that realistically represents the differences in the cost of living across different countries.
That’s why traders and economists use GDP per capita. Adjusted for the size of the population, China’s GDP per capita comes in at $8.800. In comparison, the Swiss GDP per capita stands at $80.200. Does this mean the Swiss are 10x better off than the Chinese? Not necessarily, as the cost of living is significantly higher in Switzerland.
Finally, to compare the Chinese and Swiss GDPs from a realistic standpoint, economists use the purchasing power parity (PPP) approach. PPP uses a basket of items to determine how many goods and services an exchange-rate-adjusted unit of money can buy in each country.
Taking PPP into account, China’s GDP per capita rises to $18.000, while Switzerland’s drops to around $64.000, as of 2018.
How to Trade the GDP Report?
As with other important economic indicators, the GDP report can occasionally create large volatility and price movements in the market, especially when the actual number comes in way below or above market expectations.
The best way to trade the GDP report is by using the advance GDP release. This is the first release that hits the newswire and tends to have the largest impact on the market. When the final GDP gets released two months later, most of the information has already been priced in by the markets.
Alternatively, many traders try to anticipate the actual GDP number by following other leading indicators that impact the GDP, such as stock indices, personal consumption, and housing starts, to name a few.
The GDP report is the broadest measure of a country’s economic activity and includes the total value of all goods and services produced within a country in a specific period of time.
There are three main GDP releases:
… released around one month apart.
The advance report tends to have the largest market impact as it is the first report to be released.
Traders can get a solid picture of a future GDP report by following important leading indicators, such as retail sales, personal consumption, stock indices, and housing starts. Personal expenditure accounts for around two-thirds of the total economic activity in a developed country and is a major indicator of upcoming recessions.