Finding a level of understanding that supports your decision-making without overloading you with unnecessary information is essential for being a competent investor. Discover how GDP and inflation affect the market, the economy, and your investment portfolio.
Understanding Inflation
Inflation is defined both as an increase in the money supply circulating within an economy and as an increase in overall price levels. Economists often calculate inflation rates by comparing current prices to previous yearly price levels. The core Consumer Price Index (CPI) is the standard baseline used for calculating changes in inflation rates.
Furthermore, increased production of money from the central bank (e.g., The Federal Reserve) frequently correlates to a spike in price levels of goods and services soon thereafter.
Understanding Gross Domestic Product (GDP)
A country’s gross domestic product (GDP) is a measure of all economic output in a country. GDP is determined by aggregating the income and production levels of all industries within a country for that year. Products and services produced within the country for local and international consumption (export) and inflowing remittances comprise the bulk of a nation’s GDP.
The Link Between GDP and Inflation
Inflation and GDP are intricately linked and changes in one frequently affect the other. Prudent investors often monitor GDP and inflation shifts to understand how their investment portfolios will be affected by these fluctuations.
It’s important to remember that the GDP estimates provided to investors have already undergone an inflation adjustment. In other words, if inflation was determined to be 2% over the same period but the gross GDP was calculated to be 6% greater than the previous year, GDP growth would be recorded as 4%—or the net increase over that time.
Annual GDP growth is an important factor for stock market investors. Most businesses won’t be able to improve their earnings if the overall economic production is slowing down or stagnating.
However, excessive GDP growth is also risky since it almost certainly accompanies a rise in inflation, which reduces the purchasing power of money and reduces future corporate earnings. The majority of economists concur that 2.5 to 3.5% annual GDP growth is the maximum that an economy can sustain without having unfavorable repercussions.
How the Unemployment Rate Affects GDP and Inflation
A country’s unemployment rate also affects the complex balance between inflation and GDP. Research shows a 0.5% decrease in the unemployment rate every time GDP growth rises beyond 2.5% yearly within the last 20 years.
Low unemployment rates, however, can actually be detrimental since a high employment rate often causes a rise in the prices of goods and services. Higher employment means more purchasing power and increased demand for goods and services. Prices will increase once the overall demand for products and services grows faster than its supply.
Furthermore, a tight labor market will force businesses to raise wages. As businesses strive to maximize profits, the burden of low supply typically gets passed on to consumers in the form of higher prices.
Hyperinflation
Continuous GDP growth creates inflation over time. Uncontrolled inflation has the potential to turn into hyperinflation. Once established, this process can quickly create a self-perpetuating feedback loop that will be difficult to mitigate. This is because, in an inflationary environment, people will spend more money. After all, they expect it to be less valuable in the future. This promotes further short-term rises in GDP, resulting in further price increases.
The majority of economists today concur that a modest level of inflation, around 2% annually, is the ideal rate that will attract more investors into the stock market and offset any potential for hyperinflation.
Advantages of Inflation
Increased inflation frequently has little to no impact on GDP because salaries typically rise along with prices. Conversely, higher GDP growth is associated with lower inflation, since higher economic output increases supply, which reduces relative demand and drives down prices.
With the right strategy, investors should not be afraid to invest more despite high inflation rates because prices will eventually return to average levels. Furthermore, increased economic production will be beneficial to the economy in the long run.
Certain people also gain benefits from inflation. For instance, borrowers can profit because when the value of money decreases, it becomes essentially less “expensive” to repay the money they have borrowed. Homeowners and real estate dealers also stand to gain because rising prices increase the value of their property.
Why Should Investors Keep an Eye on Inflation?
Keeping an eye on inflation is especially important for fixed-income investors since future income streams must be discounted by inflation to estimate how much value today’s money will have in the future.
Inflation, whether real or expected, pushes stock investors to take on the greater risk of investing in the stock market to achieve the highest real rates of return.
Real returns, the ultimate gauge, are the returns on investment after commissions, taxes, inflation, and any other frictional expenses are deducted. As long as inflation is moderate, the stock market outperforms fixed income and cash in terms of actual returns.
Conclusion
Since there are so many other aspects that need your attention as an investor, there are times when it is most advantageous to just accept the GDP and inflation numbers at face value and move on.
However, it is useful to revisit the underlying theory behind the figures from time to time to put your future investment returns into the correct perspective.
Want to improve your market research abilities as an investor? Regardless of the overall economic condition, investing in financial education is always a worthwhile investment. Schedule a FREE appointment with Mulland Fraser Japan today, and one of our skilled financial advisors will be pleased to assist you.
