Time to disconnect economics and markets

Richard Dunbar, investment director at SWIP, explains why strong GDP growth does not necessarily translate into healthy investment returns.

As learned commentators point us in the direction of Asian expansion or Latin American opportunity, it is interesting to note that the academic research does not support this collective enthusiasm for chasing GDP growth.

When strategists lay out the prospects for economic growth, sensible investors should make a mental note to look elsewhere in the presentation for the data that really matters.

Jay Ritter, in his 2004 paper, and Dimson et al in their 2002 paper, have analysed returns over a century – a timescale within most investors’ definition of the long term. Ritter says most investors believe that economic growth benefits shareholders. But his study finds that the cross-country correlation of real stock returns and per-capita GDP growth is actually negative.

Equity returns

For stock returns, what matters is how much of an economy’s growth comes from reinvestment of earnings into profitable investments in existing publicly-traded companies.

Ritter argues that the existing owners of capital frequently fail to gain from a nation’s economic growth in the shape of higher returns. The biggest beneficiaries are often private companies or buyers of new equity from existing companies.

Looking back over the past few decades, examples of Ritter’s observations are easy to find. In virtually every corner of the world, higher savings rates have led to an application of new capital, resulting in economic growth.

In the emerging markets, growth has been generated by the more efficient utilisation of labour (mainly via urbanisation, a phenomenon mentioned in virtually every developing world market strategy note). But that growth has not necessarily translated into higher returns for the original owners of equity capital.

Fellow academic Jeremy Siegel did similar research over a shorter time period from 1970 to 1997, finding the same negative correlation. He suggested two reasons for this, which perhaps may chime with the current generation of investors.

He noted first that the largest firms on an exchange may be multi-nationals, whose profits depend on worldwide rather than domestic economic growth. (Investors in the UK’s FTSE 100, where two-thirds of the profits from the constituents are derived from outside the UK, may recognise this.)

Siegel also notes that over this shorter time period the high valuation ascribed to Japanese stocks at the start of the period reflected more than was even possible with the growth that came (and then went).