Where does economic growth come from?

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Almost daily we all see headlines about economic growth – here in the UK and elsewhere (especially the US, given its size and impact on the rest of the world). Yet what it is exactly, and what are the main drivers behind economic growth? More specifically, how does all of this affect investors who are looking to navigate the economy and markets effectively for strong returns?

Below, our team at Bure Valley Group offers some thoughts on these important questions. We hope you find this content useful.To find out more about our EIS and other investment opportunities, visit our portfolio page here. To enquire regarding our latest projects and funding, you can reach us through:

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What is economic growth?

“Growth” is usually equated with “GDP growth” (i.e. gross domestic product), which refers to the increasing value of goods and services – such as food, cars and mobile phones – in an economy within a given timeframe. If GDP is 2% in a specific year, then this means that these goods and services have risen by 3% over this time. Rising GDP typically means an economy is in good health, since more goods and services are available to people to consume.

 

Drivers of economic growth

Many factors can lead to a rise or fall in economic growth. However, two main drivers are often deemed most important. Firstly, an increase in the size of the workforce tends to increase the size of the economy – suggesting why authorities usually try to reduce unemployment. Secondly, rising productivity of that workforce (i.e. output per hour worked) usually leads to a rise in per capita GDP and income – allowing people to enjoy a higher standard of living without needing to work longer hours. 

 

Where could growth come from in 2021?

For at least 18 months now, the shadow handing over the economy has, undoubtedly, been COVID-19. Since March 2020, people across the world have been forced to work from home where possible and to self-isolate. This has led, in turn, to a rise in savings and more people have been able to defer their mortgages, avoid commuting costs and spend less on leisure activities involving travel (e.g. eating out). Naturally, this contributed to a big contraction in the UK economy – which saw a 1.5% GDP shrinkage in Q1 of 2020, alone.

With the UK economy now reopening following the (apparent) success of its vaccination programme, this raises the question about how an ease in lockdown will affect growth in the coming months. One concern is that inflation might rise dramatically now that people can go out more and spend the savings they have built up. There is some indication of this, with inflation currently sitting slightly above the Bank of England’s (BoE) 2% target – and forecast to possibly rise as high as 4% by the end of the year (which would be a 10-year high).

 

How growth could affect investors

The central concern about inflation for investors is that this puts pressure on their long-term purchasing power. If inflation goes up to 4%, for instance, then UK investors need to generate at least 4% returns in their portfolio just to break even. Supposing inflation was 2% the year prior, this means that the investor must generate an extra 2% returns this year just to match their previous performance. 

Rising inflation can also drive investors towards riskier investments in pursuit of these higher returns. For example, fixed-income securities (e.g. UK government bonds, or gilts) retain the same payments to the investor until they mature – not rising with inflation. One way to address this is to consider inflation-linked bonds which allows the principal to retain its spending power. However, many others will turn to more volatile assets instead – such as stocks – which offer the potential to generate a higher return.

Inflation also impacts interest rates. Generally speaking, the more inflation rises the greater the pressure will be on central banks (like the BoE) to increase interest rates to try and “cool down” the economy. This raises the cost of borrowing and encourages people to save more – as such, potentially reducing consumer spending in the overall economy. Higher interest rates also raise the attractiveness of bonds, which partly base their rates on the base rate. The higher the yield on a bond, the more investors may consider moving parts of their portfolio out of stocks and into fixed-income securities instead. If this is not handled carefully, this could lead to a stock market “crash” (or bear run) – so central banks are normally cautious to raise rates gradually and slowly. 

In 2021, the BoE has declared, unusually, that – despite rising inflation – it will keep the UK at its current historic-low base rate of 0.10% for the time being. However, there may be a rise next year. Here at Bure Valley Group, we will keep our investor network updated about how the wider UK economy develops and how this might impact portfolios in the months and year ahead.

 

Invitation

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