The truth about economic growth and stock markets

Robert Keavney debunks the widely held view that strong economic growth is linked with the performance of a country’s stock market.

There is a broadly accepted theory that the sustained high growth rates of the BRIC countries make their stock markets especially attractive.

In this article I will argue that one could be just as successful by picking countries to invest in based on the colours on their flag rather than their rates of economic growth.

I will be able to offer solid statistical evidence to support this seemingly absurd assertion.

Is growth good?

The fact that few readers will need to be told what the acronym BRIC represents is an indicator of the popularity of the idea that Brazil, Russia, India and China offer the potential for superior equity returns.

In a very simplified form, the theory behind this is:

• First Premise: China, Russia, India and Brazil have experienced, and will continue to, experience high rates of economic growth.
• Second Premise: High growth countries have better performing stock markets.
• Conclusion: Therefore the BRICs offer the prospect for superior equity returns.

If the premises were true, then the conclusion would be eminently sensible.

Promoters of BRIC investing usually present reams of evidence in support of the first premise: how many cities are built each year, how many power stations are constructed, how many people are moving from the country to the city, and so on. Without doubt, the statistics are impressive.

I will note in passing that, at some point, there must be a risk of over-investment in some areas, but not having made a study of it, I will let the first premise pass without further comment.

However, the second premise must not be allowed to pass without questioning whether there is supporting evidence for it.

Prima facie, it seems credible that a high growth economy will produce a high growth equity market. However, we must allow the facts to get in the way of a good story.

The historical evidence

My late father used to tell me that anyone can be forgiven for being wrong with their opinions, but one should make a thorough attempt not to get the facts wrong.

So let us consider whether, historically, high rates of economic growth are actually correlated with above average equity returns.

We’ll focus on real returns, since gross domestic product (GDP) is a real number and equities returns should be compared like-for-like.

The longest-term research into this question is presented in Triumph of the Optimists by Dimson, Marsh and Staunton.

This study covers sixteen industrialised nations over the 101-year period from 1900 to 2000. The authors undertook the substantial task of recreating equity returns over this period, correcting for the ‘survivor’ and ‘easy data’ biases found in common indices.

To give a brief explanation of these: survivor bias leads to an over-estimate of historical returns by ignoring companies which failed.

For example, consider two companies, A and B, which were listed on a market in 1900. Company A survives to this day, so there is a possibility of reconstructing its historical return.

On the other hand, B became bankrupt in 1905 and no data still exists about its shares. In fact, there may be no evidence of the existence of a company that was bankrupted so long ago.

A portfolio constructed in 1900 that was spread equally over A and B would have lost half its original capital in 1905 when B folded.

However if an index was created today, intended to represent market returns beginning in 1900, it will include A but not B — thereby materially overstating equity returns over the period from 1900 to today.

As an example of easy data bias, we can consider the situation just hypothesised.

These days, if we wish to know the historical returns from the US, the Australian or any other market, we simply look at an index.

The index could be flawed, as just explained — but we rely on it as it is easy to access.

Dimson, Marsh and Staunton report that these biases have “provided investors with a misleadingly favourable impression of long-term equity performance”.

The section of Triumph of the Optimists that is relevant for our enquiry is the relationship between economic growth (real per capita) and total equity returns in the sixteen countries over more than a century.

They report separately the outcome for 1900-1950 and 1951-2000. The correlation for these periods was -27 per cent and -3 per cent (note the minus signs).

To report one specific anomaly, Italy suffered the lowest growth rate over the twentieth century, yet enjoyed a more profitable stock market than did Sweden, which had the highest rate of growth.

On the basis of this data we could suggest a tentative hypothesis: that high growth economies tend to be associated with low returns on equities, but the relationship is not strong.

However, many factors can affect stock markets beside economic growth, so perhaps growth of dividends would be a better proxy for the profitability of companies.

Dimson, Marsh and Staunton also examined the correlation between real per capita GDP growth and the increase in real dividends. The correlation was -53 per cent!

Other sources

Other studies have been done over shorter periods. Prof Jay Ritter of the University of Florida calculated the relationship between GDP and stock markets for 15 emerging countries to be 2 per cent.

He studied the 1988-2002 period. The paper, Economic Growth and Equity Returns, was published in 2004.

This result essentially suggests no relationship between strength of an economy and the performance of shares in those economies.

Professor Jeremy Siegel of the University of Pennsylvania published a study in 1997, examining the 1970-1997 period.

He found a correlation of -32 per cent for 17 developed countries and -3 per cent for 18 emerging markets.

This echoes the picture presented by Ritter: that there is a negative relationship for industrialised nations and no relationship for emerging markets.

The above studies point to a common conclusion. In developed nations there is a negative relationship between growth and the profitability of stocks.

In developing nations there is no relationship.

Readers can draw whatever conclusions they wish from the foregoing, as long as it is not that high-growth economies are likely to deliver better return to investors.

I fear that some readers must be struggling to grasp how this could possible be so.

Before attempting to answer this question, it may help comprehension to recognise that the same situation exists in our own country and in our own recent experience.

In Australia, the decade of the 1970s produced very poor equity returns.

By contrast, the 1990s saw spectacular equity returns.

Yet growth in the two decades was similar, in fact slightly stronger in the 1970s.

Turning to recent history, the All Ordinaries Index collapsed during the GFC, yet Australia did not enter a recession.

China sustained rates of growth through the crisis that most other countries salivated over. Yet the Shanghai index lost almost 70 per cent in about a year following its October 2008 peak.

So it is in our experience that economies and equity markets often are unrelated.

Why is it so?

Reported below are several proposed explanations for the generally negative relationship between markets and economies.

Before addressing them it is important to recognise that whether they are convincing or not is irrelevant. The historical facts set out above remains.

Siegal argues that economic growth prospects are already factored into prices at the start of the period but that there was over-optimism in the forecasts in high growth nations.

But this theory is untestable — how would we know what expectations there were for future growth in 1900?

Ritter’s argument seems more convincing. He acknowledges that economic growth is beneficial. Richer countries have better health, longer life expectancy and higher wages.

However, he reminds us that investors only realise returns on the stocks they hold.

If an economy grows other companies are likely to come into existence and existing companies are likely to issue more shares.

These will increase the overall market capitalisation, as might be expected in a strongly growing economy. Governments will take on public servants. But none of these necessarily add to the return of a given shareholding.

Ritter suggest that the high real growth rates in emerging markets is largely due to high savings rates and the more efficient utilisation of labour.

Yet the fact that others save money, or that existing stock investors may produce future savings, does not necessary add one cent to the value of their existing portfolios.

Further, if the increased productivity of labour is widespread it may benefit equally the companies he holds stocks in, and their competitors — so there may be no increase in their portfolio returns.

America has provided a clear example of this. Over the last century the USA has grew into the most powerful nation in the world with the largest capital markets.

Does this mean that American shareholders in 1900 have done well?

Unfortunately not. More than 60 per cent of US market capitalisation in 1900 was railroad companies. In 2000 railways represented 0.3 per cent of market capitalisation.

Long-term railway stock holders have missed out on the growth over America over 100 years. Economic growth does not have to flow into equity returns.

Waving the flag

Above I suggested that there could be a better correlation between the colours on the flags of nations and their stock market performance than between their GDP and market returns.

I admit I have not tested this, and certainly will not take the time to do so.

However, I am prepared to assert that flag colours will be utterly irrelevant to stock market returns.

On these grounds, it is reasonable that the correlation will be in the order of zero. Nil correlation is meaningless, but slightly better than the often negative correlation using economic growth.

I should make absolutely clear that I have expressed no views on investment in high growth nations.

I have made no attempt to assess the prospective returns from China, India, Russia or Brazil, or any other high growth nation. I do not wish to encourage or discourage investors from taking opposition in these countries.

Once upon a time, investors expected to buy emerging markets at a discount. Recently they have been prepared to pay a premium. This raises the question of value.

The biggest single influence on investment returns has always been the price paid on purchase. If equity positions are taken at reasonable prices in BRIC countries, and if those countries remain stable, I know of no reason why satisfactory returns would not be achieved.

However, if investors are considering this as an option, they should do so on grounds with a robust basis. The evidence suggests that high growth rates alone are not a robust basis.

Robert Keavney is an industry commentator.