EXPLAINER: The business cycle and GDP

(iStock)
(iStock)

Every day we hear the South African economy is struggling and that business conditions are tough. But what exactly does this mean and more importantly, how do we measure the strength of the economy?

The Gross Domestic Product

When economists on radio and television tell you that the Gross Domestic Product, or GDP in short, increased or decreased, what do they refer to?

The GDP is simply a monetary measure of all goods and services that South Africa as a country produces. In its simplest form, GDP can be measured by adding all consumption, investment, government spending and exports and subtracting imports.

Let's look at each one of these:

  • Consumption: This measures how much South Africans spend on consumption of goods and services. When buying groceries, toasters, refrigerators, shoes etc - it all gets added to the consumption figure.
  • Investments: This is when businesses and corporations undertake new investments that involve the purchase of goods that assist in the production process. Goods include machinery, stock, construction etc. It is important to note that the figure is a gross figure and includes depreciation. When a business replaces one machine with another after the useful life of that machine, output does not necessarily increase. Therefore, we must add depreciation to get to a more realistic figure.

Another component in the investment figure is newly built residential and commercial buildings. The sale of existing buildings is not included.

  • Government spending: This section tracks what government spends the taxpayers’ money on. Spending includes purchases of aircrafts, salaries, grants, etc.
  • Exports minus imports: Exports and imports have an opposite effect on GDP. Exports increase GDP while imports decrease GDP. Thus, a trade surplus will increase GDP while a trade deficit decreases GDP.

Why the GDP fluctuates

The GDP fluctuates because of the business cycle. The business cycle or economic cycle, is a combination of upswings and downswings. The average economic cycle usually lasts around 4 to 6 years. In years where the economy is doing well, wage growth puts upward pressure on prices, eventually leading to an increase in interest rates. The higher rates lead to credit pressure and the economy slows down again. A simplified view of the business cycle will look something like the graph below.

South African GDP and business cycle

It is very hard to predict the GDP accurately into the future. However, trends can be predicted. Economists try to predict these trends by looking at leading business cycle indicators. Each month the South African Reserve Bank (SARB) publishes the composite business cycle indicators.

Recently the business cycle indicators for April 2018 was released. The full report is available on their website. Looking at the leading (predictive) business cycle indicator, we are seeing a positive trend since around early 2016.  Leading indicators look at economic activity 6-9 months ahead.

            Source: South African Reserve Bank, Composite Business Cycle Indicators June 2018

From the graph above it seems that if the leading economic indicator is anything to go by, the South African GDP might very well deliver a surprise to the upside going forward. As Warren Buffett famously said, “Be fearful when others are greedy, be greedy when others are fearful."

*Kirk Swart is an analyst at Overberg Asset Management, an Authorised Financial Services Provider (No 783) which specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: The above article does not constitute financial advice and is not a recommendation. Investors must always seek the advice of professionals and trade with caution. Under the ECT Act and to the fullest extent possible under the applicable law, Fin24 disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner.

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