Economic Growth

CFA Level 2 | Economics | Learning Module 2

Growth In The Global Economy

Forecasts of long-run economic growth are important for global investors because equity prices reflect expectations of future earnings, which depend on future economic activity.
In the long term, the same factors that drive economic growth will be reflected in equity values.
The expected long-run growth rate of real income is a key determinant of the average real interest rate level.
In the shorter term, the relationship between actual and potential growth is a key driver of fixed-income returns.
Investors need to identify and forecast the factors that drive long-term sustainable growth trends to develop global portfolio strategies and investment return expectations.
The study of economic growth focuses on the long-run trend in aggregate output as measured by potential GDP, in contrast to the short-run fluctuations of the business cycle.
Over long periods, the actual growth rate of GDP should equal the rate of increase in potential GDP because output in excess of potential GDP is unsustainable.
The growth rate of potential GDP acts as an upper limit to growth and determines the economy’s sustainable rate of growth.
Increasing the growth rate of potential GDP is key to raising income, profits, and the living standard.
Economic growth is calculated as the annual percentage change in real GDP or in real per capita GDP.
Real per capita GDP reflects the average standard of living.
Growth in real GDP per capita implies a rising standard of living.
Cross-country comparisons of GDP should be based on purchasing power parity (PPP) rather than current market exchange rates to account for differences in the prices of non-traded goods and services.
Developed economies tend to be those with high per capita GDP, but there are no universally agreed-upon criteria for classification.
Developed and developing countries differ with respect to the presence or absence of appropriate institutions that support growth.
The literature on economic growth primarily focuses on the role of capital and labor resources and the use of technology as sources of growth.

Factors Favoring And Limiting Economic Growth

A major problem for some developing countries is a low level of capital per worker.
Countries accumulate capital through private and public sector investment.
Increasing the investment rate may be difficult in developing countries due to low levels of disposable income.
Growth depends on how efficiently saving is allocated within the economy.
The financial sector channels funds from savers to investment projects.
Financial markets and intermediaries can promote growth by screening and monitoring borrowers, encouraging savings and risk-taking, and mitigating credit constraints.
Free trade generally benefits an economy by providing more goods at lower costs and increasing competition.
Factors limiting growth in developing countries include low rates of saving and investment, poorly developed financial markets, weak legal systems, lack of property rights, political instability, poor public education and health services, discouraging tax and regulatory policies, and restrictions on international trade and capital flows.
Lack of physical, human, and public capital, as well as little or no innovation, can also limit growth in developing countries.
Sustained differences in GDP growth rates over decades significantly alter the relative incomes of countries.
Preconditions for economic growth include well-functioning financial markets, clearly defined property rights and rule of law, open international trade and capital flows, an educated and healthy population, and encouraging tax and regulatory policies.

Why Potential Growth Matters To Investors

The long-run rate of stock market appreciation is related to the sustainable growth rate of the economy.
Equity prices reflect expectations of the future stream of earnings, which depend on expectations of future economic activity.
Potential GDP and its growth rate matter for equity and fixed income investors.
Expected equity return can be decomposed into dividend yield, expected repricing, inflation rate, real economic growth, and change in shares outstanding.
Changes in P/E ratios (repricing) may trend higher with increasing GDP growth as investors perceive less risk.
Dilution effects, such as net buybacks and relative dynamism (issuance of new shares or reduction in outstanding shares due to factors like privatization or delistings), can cause divergence between real economic growth and equity returns.
Simply extrapolating past GDP growth can produce incorrect forecasts because a country’s growth rate can change over time.
Changes in economic factors and policies that affect potential growth have a large compounded impact on living standards and economic activity, which in turn affects long-run stock market returns.
Potential GDP forecasts can gauge inflationary pressures arising from cyclical variations in actual output growth relative to long-term potential growth.
Actual GDP growth above (below) potential GDP growth puts upward (downward) pressure on inflation, affecting nominal interest rates and bond prices.
A higher rate of potential GDP growth improves the general credit quality of fixed-income securities.
Monetary policy decisions are affected by the output gap and the growth of actual GDP relative to potential GDP.
Government budget deficits are often judged relative to structural or cyclically adjusted deficits, which assume the economy is operating at potential GDP.
Long-term real GDP growth rates tend to be far less volatile than equity returns, especially for developed economies.
For countries with prudent monetary policies, inflation rates are also less volatile than stock prices.
Forecasts of long-term real and nominal GDP growth may be more reliable than equity market return forecasts based solely on historical equity returns.
When actual GDP growth is forecasted to be well below potential GDP growth, it suggests a growing output gap, potentially leading to downward pressure on inflation and lower short-term interest rates, which can cause bond prices to rise.

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