Importance of Inflation and GDP for a Investors Portfolio

Introduction :
Investors are likely to hear the terms inflation and gross domestic product (GDP) just about every day. They are often made to feel that these metrics must be studied as a surgeon would study a patient's chart prior to operating. However there are no absolute value which can be fixed for both the financial parameters as to what is ideal growth rate of GDP or Inflation. It is highly subjective depending upon the investor portfolio with respect to economy

What is Inflation ?
Inflation can mean either an increase in the money supply or an increase in price levels.Generally, when we hear about inflation, we are hearing about a rise in prices compared to some benchmark. For eg : In India WPI (Wholesale Price Index) is used as standard measurement of inflation in financial markets.

 What is Gross domestic product ?
The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country. It is the market value of all final goods and services made within the borders of a country in a year. It is often positively correlated with the standard of living, alternative measures to GDP for that purpose. It is important to keep in mind that the GDP figures as reported to investors are already adjusted for inflation. In other words, if the gross GDP was calculated to be 6% higher than the previous year, but inflation measured
2% over the same period, GDP growth would be reported as 4%, or the net growth over the period.

Relationship: Double Edged Sword :
The relationship between inflation and economic output (GDP) plays out like a double edged sword.
One side of sword :
For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. 
Second Side of Sword : 
too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money  less valuable. 
Fact :Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects.


But where do these numbers come from?
 For understanding this we have to also introduce the variable known as  "Employment Rate".
Studies have shown that over the past 20 years, annual GDP growth over 2.5%  has caused a 0.5% drop in unemployment for every percentage point over 2.5%. It sounds like the perfect way to kill two birds with one stone - increase overall growth while lowering the unemployment rate, right?
Unfortunately this isnt that easy because this positive relation starts to break when economy moves towards full employment rates.
Consequences of Full Employment :
Near full employment will cause two important things to happen:

1) Aggregate demand for goods and services will increase faster than supply, causing prices to rise.
2) Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits. 

Key point: Companies will have to raise wages as a result of the tight labor market. This increase usually is passed on to consumers in the form of higher prices as the company looks to maximize profits.(it increases at increasing rate).

Analysis of Monthly Movement of SENSEX and Inflation rate for the year 2010 :

 Observation from diagram : From the above two charts it can be observed that as the inflation decreases SENSEX rises upwards which might leads to increase in REAL INCOME of the investor. 

So is Inflation a "bad thing" for any economy :
Answer is NO,The biggest reason behind this argument in favor of inflation is the case of wages. In a healthy economy, sometimes market forces will require that companies reduce real wages, or wages after inflation.In a theoretical world, a 2% wage increase during a year with 4% inflation has the same net effect to the worker as a 2% wage reduction in periods of zero inflation.But out in the real world, nominal (actual) wage cuts rarely occur because workers tend to refuse to accept wage cuts at any time. This is the primary reason that most economists today agree that a small amount of inflation, about 1-2% a year, is more beneficial than detrimental to the economy.


What do investors do ???? 
Fixed Income Investors :
Keeping a close eye on inflation is most important for fixed income investors, as future income streams must be discounted by inflation to determine how much value today' money will have in the future. Also Inflation rate can also important determinant for YTM in the Glitz Market.
Stock Market Investor :
For stock investors, inflation, whether real or anticipated, is what motivates us to take on the increased risk of investing in the stock market, in the hope of generating the highest real rates of return. Real returns are the returns on investment that are left standing after commissions, taxes, inflation and all other frictional  costs are taken into account.
Further Conclusion :  As long as inflation is moderate, the stock market provides the best chances for this compared to fixed income and cash.

My View :  Other than Inflation and GDP there are many things which demand our attention as an investor  however, it is valuable to re-expose ourselves to the underlying theories behind the numbers from time to time so that we can put our potential for investment returns into the proper perspective.:-)

Sources : www.Investopedia.com, Wikipedia, www.yahoo finance.com,www.tradingeconomics.com