Effects of Potential GDP Growth Rate on Equity and Fixed Income

One of the uses of the GDP is the control of the effects of inflation on the economy. If the real GDP growth is higher (lower) than the potential growth rate, then the inflation rate will increase (decrease), affecting the nominal rates and bond prices.

Moreover, potential GDP determines the level of real interest rates and hence, the asset returns in the economy. If the potential GDP grows at a faster rate, then consumers would expect their income to rise. In other words, a rise in real interest rates occasions an increment of savings for capital accumulation. Therefore, a higher growth rate of the potential GDP means higher interest rates and expected asset returns.

More effects of potential GDP and its growth rate on equity and fixed income analysis are summarized below.

Impact of Potential GDP and its Growth Rate on Equity and Fixed Income

1. When the potential GDP growth rate is high, fixed-income securities’ general credit quality tends to improve. Securities associated with fixed income are supported by the flow of income even if a lender owns some of the underlying assets.
2. The monetary policy decisions are based on resource usage and a flapping economy. Therefore, monetary decision policy is affected by the output gap (difference between the anticipated potential output and actual operating level) and actual GDP relative to the sustainable growth rate. Therefore, fixed-income investors need to gauge the output gap and real and potential GDP growth rates to estimate the probability of a change in monetary policies.
3. The agencies responsible for credit rating utilize the potential GDP growth rate as a factor in assessing the credit risk of external and government-issued debts. Therefore, slower growth of the potential GDP increases the credit risk.
4. Government budget deficits increase during a recession and decrease during expansion periods. The analysis of a fiscal policy is, therefore, anchored upon the structural or doubtfully modified deficits. That is, according to a budgetary equilibrium in an economy running at a potential GDP.

Question

Over the past several years, the stock market of a country has appreciated substantially. Moreover, the corporate profits to GDP ratio have been increasing over the same period and have surpassed the historical mean. Based on this information, the corporate profits to GDP ratio of this country is most likely to:

1. Decrease from its present measure.
2. Increase from its present measure.
3. Remain near its present measure.

Solution

The correct answer is A.

The corporate profits to GDP ratio of this country have been rising over the years, but it won’t do so forever. Simultaneously, the constant labor income would prompt the workers to halt their work unless the wages are increased. In turn, this will undercut the demand, making the profit margins unsustainable. Therefore, it is probable that the corporate profits to GDP ratio will decrease in the long run, tending to its historical mean.

Reading 7: Economic Growth 

LOS 7 (c) Explain why potential GDP and its growth rate matter for equity and fixed income investors.