Gross domestic product (GDP) reigns as the key gauge of a country’s economic health. Pioneered by Simon Kuznets in the 1930s, it measures the total value of goods and services that a country produces. Forecasting GDP growth has taken on huge importance…perhaps too much.

Wall Street uses GDP growth forecasts as a basis to allocate capital, businesses use them to make production and investment decisions, and policymakers use them to guide economic planning. “Without measures of economic aggregates like GDP, policymakers would be adrift in a sea of unorganized data,” says the US Bureau of Economic Analysis.

A GDP release is a closely watched event that generates news headlines and moves markets. An industry has even grown up around compiling GDP forecasts. Consensus Economics polls hundreds of economists each month for their forecasts, including GDP growth, and then sells them on for hundreds of dollars to central banks, investment managers and corporates. While there’s no doubt that GDP is a useful measure, the global financial crisis highlighted the fact that forecasting GDP is far from an exact science.

GDP’s Shortcomings

Nobel prize winning economist Joseph Stiglitz is among those leading the charge against an over-reliance on GDP. See here. He argues that GDP does not quantify the sustainability and quality of growth. The OECD has also cast a critical eye on GDP, arguing that it fails to take into account inequality and externalities, like environmental degradation. See here. Meanwhile, research has shown GDP growth is not a good leading indicator for equity market returns. A key thesis for investment in emerging markets is that they will grow faster than advanced economies…ergo, the market returns will be bigger. However, studies show the assumption about bigger market returns in fast-growing economies is not a given, raising questions about the investment community’s fixation on GDP.

Sustainability

Looking at headline GDP alone gives no indication of the sustainability of growth. Is economic output being fuelled by a dangerous buildup of debt? Is spending on investment going into activities that will enhance the country’s long-term productive capacity? For example, some – such as Nouriel Roubini of RGE – have argued that high investment spending in China is simply creating overcapacity (which is not bolstering the country’s long term growth potential). It is important to look beyond GDP to answer these questions and to critically assess the plausibility of GDP growth forecasts.

The sharp economic contraction in the Central and Eastern Europe (CEE) region in 2009, as seen in the chart below, surprised many observers.  The common belief was that the EU entry achieved by many CEE countries in 2004 had created a “halo effect” – as described by the IMF – that made these countries ‘safer’ and more attractive to investors.

However, if you look beyond GDP to debt levels, the downturn may be less surprising. Growth in much of the CEE region was debt-fuelled and unsustainable, and rising external debt levels (as seen in the chart below) were largely ignored.

Simply looking at GDP and external debt is overly simplistic, but I did it to illustrate the point that looking at these two indicators together provides a clearer picture of an economy’s future performance than relying on GDP alone.

Externalities

GDP also fails to take into account externalities. For example, overfishing would boost a country’s GDP growth in the short-term, even though it would damage the country’s natural resources and hamper long-term growth.  This creates distorted incentives. As Joseph Stiglitz notes, “[T]he focus on GDP creates conflicts: Political leaders are told to maximize it, but citizens also demand that attention be paid to enhancing security, reducing air, water, and noise pollution, and so forth—all of which might lower GDP growth.”

Income Inequality

Companies rely on GDP and population as key measures for gauging a country’s market size. However, income inequality is also of paramount importance. While GDP measures the size of the economic pie, it gives no indication of how that pie is divided. An economy may be growing, but if that growth is driven by the gains of just a handful of people, then the market for most products is not really growing.

As Jared Bernstein noted in a piece for the Economic Policy Institute. “The [US] economy of course expanded in the 2000s, but that growth clearly failed to reach most households.” He points out that inflation-adjusted median household income in the US was lower in 2007 than in 2000, despite strong GDP growth over this period. This raises the question of whether the focus on GDP growth has obscured the disturbing trend of growing income inequality in countries, such as the US, as seen in the chart below.

Instead of just looking at GDP per capita, why is income distribution important? Well, it’s needed to get a clearer picture of the economy. Here’s a quote that explains it pretty well: “Then there is the man who drowned crossing a stream with an average depth of six inches.”  ~W.I.E. Gates

Faster growth does not equal higher equity returns

Yet another reason the fixation on GDP growth is overdone…it is not a good predictor of stock market performance, according to several studies. As a recent Buttonwood column in the Economist magazine notes, this upsets a key tenet underlying the argument for investing in emerging markets – that is, they are fast growing and will therefore generate superior equity returns.

In the paper Growth and Returns in Emerging Markets, Peter Blair Henry and Prakash Kannan undermine this argument. Their finding: “Not only is the relationship between stock returns and economic growth statistically insignificant, the sign of the relationship actually goes the wrong way—it is negative instead of positive.

Interestingly, investing in slower-growing countries may turn out to be the superior strategy. According to the “Credit Suisse Global Investment Returns Yearbook” (cited by Buttonwood), investing annually in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, while investing in the lowest-growth countries returned 25.1%.