Greatly Dubious Premise III – Some very practical reasons why investors should be wary of GDP


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

In Greatly Dubious Premise I and Greatly Dubious Premise II () – and in no small part thanks to Diana Coyle’s excellent book GDP: A Brief but Affectionate History – we put together a long list of reasons why GDP numbers are nowhere near as solid or authoritative as they are generally perceived. But while that is all surprisingly interesting in theory, are there any practical reasons why investors should care? 

Did you ever doubt it? For starters, what we have seen are actually fairly arbitrary calls on what does and does not count as GDP, how the measurement of inflation and exchange rates and so on can have some strikingly important consequences – and not just in the way, as we saw in Greatly Dubious Premise I, that the change in definition of GDP served to raise Keynesianism onto its pedestal in the pantheon of economic theories. 

Arguably GDP has helped to shape political history – and very close to home as well. Consider, for example, the pivotal period in late 1976 when Denis Healey, the Chancellor of the Exchequer of the then Labour government, was forced to apply to the International Monetary Fund (IMF) because the UK’s borrowing was so out-of-kilter with the nation’s GDP figures. 

As it happens, both numbers were later revised to the extent that no loan would have been required. By then though, the savage cuts to public spending – what would now be termed ‘austerity’ – that Labour was obliged to make to obtain its IMF loan had further undermined a struggling administration and, within three years, Margaret Thatcher was in power. Clearly GDP can have significant consequences. 

A more recent example involves the so-called ‘paradigm shift’ the US economy enjoyed during the technology boom of the late 1990s. Perhaps the US had indeed managed to become a significantly more dynamic economy than its major competitors, as was widely thought at the time, or perhaps – as now seems more likely – it was all down to the way the US chose to calculate its GDP numbers. 

Not only did the US introduce ‘hedonic pricing’, which we discussed in Greatly Dubious Premise II , to take account of the huge impact of the internet, it also categorised software as investment rather than expenditure. This combination helped to push US GDP significantly ahead of its competitors – yet, as soon as those competitors followed suit, the US economic miracle looked a good deal less miraculous. 

Then there is the question of how the relatively recent change in adjusting GDP data for inflation – from a simple fixed base year to the complicated ‘chain-weighting’ calculation – may influence or alter our understanding of economics. If you believe chain-weighting is the correct way to consider GDP – as most economists do – it would present economic history in a very different light. 

As Coyle writes in her book, for example, chain-weighting historic data would show US productivity in 1914 as being much lower than that of the UK while, by 1929, there was much lower US growth and GDP than there was in the UK – all of which is entirely contrary to perceived economic wisdom. In other words, all those subsequent theoretical changes in GDP’s scope and definition really do matter. 

Lessons of history 

When the powers that be are weighing up appropriate policy responses to particular circumstances, they will naturally consider what can be learned from the history of GDP – for example, the impact on GDP of various policy actions. Yet there is now a strong argument that the conclusions economists and policymakers reach are not necessarily the correct ones, as their understanding of movements in GDP are based on a historic and flawed calculation. 

In these ways, technical and seemingly theoretical considerations such as adjusting for inflation and the most appropriate components of GDP can have profound implications for what we believe to have been the major causes of growth and economic development over the last two centuries – and this even extends to one of the most fundamental formulas in economics, GDP = C + I + G + X – N. 

Still revered by many professional investors, this formula holds that consumption plus investment plus government spending plus exports minus imports equals GDP. The trouble is, once you take all the necessary adjustments – and particularly chain-weighting – into account, it does not. What is still taught in ‘Economics 1:01’ therefore no longer works in the real world. 

As you will probably have gleaned from this trilogy of articles, here on The Value Perspective, we pay no attention to GDP-related numbers – except perhaps the following: when the first official guide to measuring GDP was published in 1953, it was just 50 pages long. By 2008, however, the same document had mushroomed to 723 pages. 

Such a statistic brings into sharp relief why there is no one person on this planet who knows everything it takes to measure GDP – the whole calculation necessitates teams of people. That being so, how on earth could anyone realistically believe they could ever forecast GDP and why on earth would any investor pay any attention to such a forecast? 

What is more, even if it were somehow possible to forecast GDP in any reliable way, there is no such thing as a GDP future that would turn such an incredible skill into a market-based investment proposition. So, even if you were extraordinarily lucky and managed to forecast GDP correctly, it would still be extraordinarily difficult to make money from that, as you need to turn your GDP call into a market position. It doesn’t need to be stated that the market has tendency to act in some very perverse ways, as can be amply demonstrated by the US dollar strengthening and US treasuries increasing in price following the US credit rating downgrade in 2011 – entirely the opposite reaction to that which would be naturally expected. 

As things stand, investing by reference to GDP is akin to attempting an accumulator at the racecourse. For your bet to pay off, you have to be right multiple times and, obviously, the more variables that are involved, the smaller your chances of success become. Ultimately, the chances of guessing the correct values for all the variables within GDP, guessing consistently over time, and then turning it into a consistent market beating investment proposition are all but nil so, here on The Value Perspective, we do not even try. Instead, we focus our time on gaining a profound understanding of valuations, and the significant insight and investment edge we can gain from that effort.


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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