Identifying which economic variables may be most relevant to the current economic environment and discerning or forecasting changes in acceleration and deceleration of a trend can convey a competitive advantage.
Economic output has both cyclical and trend growth components. Trend growth is of obvious relevance for setting long-term return expectations for asset classes such as equities. Cyclical variation affects variables such as corporate profits and interest rates, which are directly related to asset class returns and risk.
Exogenous Shocks and Endogenous Shocks
Exogenous shocks are unanticipated events that occur outside the normal course of an economy
- Policy changes. Elements of pro-growth government policies include sound fiscal policy, minimal intrusion on the private sector, encouraging competition within the private sector, support for infrastructure and human capital development, and sound tax policies.
- New products and technologies. Creation and assimilation of new products, markets, and technologies enhances potential growth.
- Geopolitics. Geopolitical conflict has the potential to reduce growth by diverting resources to less economically productive uses (e.g., accumulating and maintaining weapons, discouraging beneficial trade).
- Natural disasters. Natural disasters destroy productive capacity. In the short run, a disaster is likely to reduce growth, but it may actually enhance long-run growth if old capacity is replaced with more efficient facilities.
- Natural resources/critical inputs. Discovery of new natural resources or of new ways to recover them (e.g., fracking) can be expected to enhance potential growth, directly or indirectly.
- Financial crises. The financial system allows the economy to channel resources to their most efficient use.
Endogenous shocks are normal trends in an economy are built into market prices
Implications of Expected Trend Rate of Economic Growth
The expected trend rate of economic growth is a key consideration in a variety of contexts.
- First, it is an important input to discounted cash flow models of expected return.
- Second, a country with a higher trend rate of growth may offer equity investors a particularly good return if that growth has not already been priced into the market.
- Third, a higher trend rate of growth in the economy allows actual growth to be faster before accelerating inflation becomes a significant concern.
- Fourth, theory implies, and empirical evidence confirms, that the average level of real government bond yields is linked to the trend growth rate. Faster trend growth implies higher average real yields.
Components of GDP Growth
Two main components of analysis of the economy’s aggregate trend growth are:
- growth from labor inputs:
- growth in potential labor force size and
- growth in actual labor force participation
- growth from labor productivity:
- growth from increasing capital inputs
- growth in total factor productivity
- Basic model to forecast economic growth rate:
- Labor input + capital per worker + total factor productivity (TFP)
- Labor input = population growth + labor force participation growth
- Capital per worker = spending on new capital inputs
- TFP (residual) = technological progress and gov’t policy changes