How Much Should We Worry About GDP Growth Dropping to 2%?

GDP

Current projections have us moving from a 2.9% GDP growth rate in 2018 to around just 2% in 2019, and stay around this level until 2022. What does this mean for stocks?

There’s no question that the growth of our economy is slowing down lately. The predictions of it dropping to around the 2% level for the next 3 years on average look pretty reasonable.

We might think that, with the trend downward, the current momentum may take us below that, and wonder whether these forecasts take this momentum into account enough, and take current projections too much at face value.

When we see these numbers revised down, we may be disposed to think that. If this looked like a 2.3% year a few months ago and now looks like it will come in at 1.9%, and this wasn’t the first revision. There may be even more to come, and they may follow this downward trend, producing even smaller numbers each time.

Does the possibility of negative momentum here, like we would see with the stock market itself, make sense? Factors that influence economic growth are all connected, and if we see some things that put this down emerge, there may indeed be things behind the scenes that are affected and only show themselves in future numbers.

This is not all that hard to imagine, and something caused these recent revisions, even if that is our just coming in too high with the predictions. These are just predictions after all, and as time goes on, even our best guesses are still subject to revision.

When trends emerge here, like the one we now have where both GDP growth and our revisions of it are trending downward, this at least needs to be a concern. We also need to take stock of where we are at and see how much what we know so far may affect things. This will involve more predictions, but of a different sort, one that not involves just looking at the economy, but it’s potential effects upon the stock market.

As far as things getting worse go, we can say that the odds have to be on the side of further revisions down, because of the trend that way, but we cannot just assume that this will happen either. The approach here needs to be to just wait and watch and update our outlooks as the information that we have to work with changes.

How Stock Markets May Be Affected is an Entirely Different Question

Meanwhile, we’re left with the task of determining how the way this has all transpired so far may affect stocks. We’re seeing people project things like we may expect half of the average returns that the market has historically delivered during these lean times, or at least gains that are appreciably lower. Some think that this may or even will bring on a bear market, so there is potentially a lot on the line from interpreting these forecasts of future growth well.

Just about everyone understands that the connection between the economy and the stock market isn’t a direct one. However, the two together are quite loosely related and not anywhere near as fundamental as a whole lot of people assume. Understanding how things actually work is a real key therefore in defining what we can say about what we may expect from the stock market when things change with the economy.

We might think that, since stock prices come from business performance, and business performance and business growth are driven or at least described by changes in economic growth, we could look at economic growth and get a good idea at least about what we may expect companies, and their stocks to do.

If this were all true, we’d have a pretty good correlation at work here, and perhaps even a forward-looking relationship, as we could expect that trends in economic growth might even precede trends in the stock market. The economy shrinking now may therefore portend the stock market shrinking in turn, and soon, so this may have us more eager to exit stock positions because of this writing on the wall.

This is not how this all works though. This all ignores the effect of the market participants themselves, and is the manner in which the market wants to bid up or down stocks that is the real driver of all this. With few exceptions, our economy grows each year at various rates and this actually has little correlation with the stock market as it turns out, and all we have to do is look at how this all stacks up to get a clear picture of this.

How Big of a Deal is GDP Growth Falling to Around 2%?

If this correlation were at least fairly strong, we’d rarely see bull markets, but when we do see them, we almost always see some pretty good growth go along with them. We don’t have to look any further than the pullback of late 2018 to see this, where growth has declined since then but the market is up quite a bit.

How meaningful is a drop in economic growth to 2%? If we look at GDP growth over the last 10 years, during the current bear market, we see it average 2.2% per year over this time. Yet, the stock market grew by an average of 30% over these 10 years. If 2.2% equals 30%, 2% may equal a number almost as big, if this is how these things are decided that is.

Growth dipped to 1.6% as recently as 2016, and that wasn’t the best year along the way, but we still managed to see the stock market move up by 10% that year. It’s not that these numbers don’t matter, but they only serve to influence a portion of the results, and not a big portion at that.

If we look at this 10-year performance, we could say that 2.2% of it was from economic numbers, and 27.8% of it was from buying pressure. Buying pressure just isn’t the most important factor here, it’s the deciding one. Seeing GDP numbers reduce may therefore have an effect upon buying pressure, or it may not. GDP can be very healthy but if this pressure goes away, we’re in for a real storm regardless.

Over time, this buying pressure can jack up stock prices quite significantly, and in this case, we can say that they got elevated by an extra 278%. Declining GDP numbers do have an effect upon this, but it is investors taking their profits that we need to be worried about the most here, by far actually, although this does not mean that this all will be subject to going away, as most people just hang on to their stock for the longer haul.

Profit taking is not something that you can measure by looking at fundamentals of any sort though. We can measure trends in inflows and outflows, and we can also just measure the way price is changing, where it going down will tend to attract more profit taking and even be sufficient to cause an exodus large enough to bring on an actual bear market.

On the other hand, there is no good reason why we can’t keep this all going with 2% GDP growth, like we did with the 2.2%, provided that the market is comfortable with this lower number. If people continue to put enough money in stocks, that’s what drives prices, not changes in GDP or anything else for that matter.

We therefore need to take these predictions of stock market slowdowns based upon economic slowdown with a big grain of salt. We may indeed enter a bear market over the next 3 years that these leaner forecasts are directed at, but we may not, and if we do, it won’t be because GDP growth is down to 2%, because these things play such a small role in the outcome.

We’ve been holding up quite well in 2019 though, with no real signs that this is all over, aside from people using economic data in a way that simply isn’t that predictive of stock market prices. While dropping economic numbers are by no means bullish, they aren’t that bearish either, at least the ones we’ve seen so far, and even though we’re told to expect much leaner returns, we can’t tell that much from these numbers, and this in itself is no reason for us to either panic or expect hard times.

The hard times may come, but it will come from people fleeing the stock market, like they always do when bear markets start, and we’re not seeing that happen at least yet.