Swedroe: GDP Growth Doesn’t Mean Better Returns

Conventional wisdom can be defined as “ideas that are so ingrained in our belief system they go unchallenged.” Unfortunately, much of the “conventional wisdom” about investing is wrong. One example of erroneous conventional wisdom is that investors seeking higher returns should invest in countries that are forecasted to have high rates of economic growth, such as India and China.

It certainly seems intuitively logical that, if you could accurately forecast which countries would have high rates of economic growth, you would be able to exploit the knowledge and earn abnormal returns.

Unfortunately, relying on intuition often leads to incorrect conclusions. In this case, it fails to account for the fact that markets are highly efficient in building information about future prospects into their current prices, and investors fail to understand the difference between what is information and what is value-relevant information. The historical evidence on the correlation between country economic growth rates and stock returns demonstrates this point.

A Study Of Growth And Returns
The latest evidence comes from an August 2016 research paper from Dimensional Fund Advisors, “Economic Growth and Equity Returns.” Examining the data on 23 developed-country markets over the 40-year period from 1975 through 2014, and for 19 emerging markets over the 20-year period from 1995 through 2014, DFA found no significant relationship between short-term economic growth rates and stock returns.

Countries were classified each year as either high or low growth depending on whether their GDP growth was above or below that year’s median, defined separately for developed and emerging markets. Researchers then looked at the stock market returns of high- and low-growth countries over the following year.

The return for each group is the average stock market return of all the countries in that group weighted by countries’ market capitalization. They found not only no statistically significant relationship between economic growth and future stock returns, but in developed markets as well as emerging markets, the lower-growth economies produced higher returns.

In the developed markets group, the high-growth countries returned 12.0% in the following year, while the low-growth countries returned 13.1%, although they did so with higher volatility (21.2% versus 19.1%). In the emerging markets group, high-growth countries provided higher returns (12.9% versus 12.6%) while exhibiting lower volatility (34.9% versus 38.9%).

DFA’s researchers then asked what would happen if economists had perfect foresight, which simply doesn’t exist in the real world. With perfect foresight, you could buy the stocks of countries with high economic growth rates and avoid (or short) the countries with low economic growth rates. DFA found that the low-growth countries in the developed-markets group returned 13.2% versus 11.2% for the high-growth countries.

However, they did find that in the emerging markets group that the opposite was true. Low-growth economies returned 11.4% (with an annual standard deviation of 36.2%) versus 13.5% for the high-growth countries (with an annual standard deviation of 37.2%).

Importantly, neither of the differences in returns was even close to being statistically significant at the 5% confidence level, with t-stats of about just 0.7. And remember the strategy isn’t even implementable because we don’t have perfect foresight, or even anything close to it.

We’ll now review some of the other evidence, which I have addressed before, on the relationship between economic growth and stock returns.

Further Evidence

Joachim Klement examined the relationship between economic growth and stock returns in his study “What’s Growth Got to Do With It? Equity Returns and Economic Growth,” which was published in the Summer 2015 issue of The Journal of Investing. Using MSCI country indexes, Klement investigated the equity market returns of 22 developed and 22 emerging markets for large-cap, midcap and small-cap stocks. Prior research, which we’ll also review, had looked only at large-cap indexes.

The motivation to look at mid- and small-cap stocks is that, if smaller companies are less internationally diversified, then the cross-country correlations between mid- and small-cap stock returns should be higher than for large-cap stocks. While including small-cap stocks did limit the period covered to 1997 through 2013, the study does cover two full economic cycles in each country. Thus, the results should be representative of general tendencies.

Klement found that there was a large variation between growth in GDP per capita and equity market returns. For example, Singapore and Hong Kong show the highest growth in GDP per capita of all developed countries but some of the lowest equity returns. Conversely, Australia and New Zealand had some of the highest equity market returns, with average or below-average growth in GDP per capita.

In general, the cross-country correlations for the three market-cap segments were comparable in size and also negative across markets. Importantly, Klement was unable to find any meaningful and statistically significant correlation between real stock returns and real GDP per capita growth for any size index.

Since the economies of some countries (such as Germany, Switzerland and Korea) are more dependent than other countries (such as the United States) on exports, Klement also investigated the relationship between global growth and stock returns. While he did find a relationship, the correlations were small and only slightly positive.

In addition, Klement investigated the cross-country correlations between earnings and GDP per capita growth. Perhaps surprisingly, he once again found “the correlations remain close to zero and may even be negative.”

While it may seem paradoxical, Klement explains: “Earnings growth depends on the growth of productivity as well as input factors like labor and capital. Thus real earnings growth may be higher even when GDP per capita growth is low if a country’s population is growing rapidly.” Conversely, for various reasons, low real earnings growth in emerging markets may occur despite rapid growth of the population.

Klement’s findings confirm prior research that concluded a negative correlation between stock returns and country growth rates existed.

Economic Growth And The Investor

In his study, “Is Economic Growth Good for Investors?”, which was published in the Summer 2012 edition of the Journal of Applied Corporate Finance, Jay Ritter found:

• For 19 countries with continuously operating stock markets during the 112-year period 1900 through 2011, the correlation between equity returns and the growth rate of per capita GDP was -0.39 when measured in local currency. When measured in dollars, the correlation changes slightly to -0.32. Investors in 1900 would actually have been better off investing in the companies of countries that experienced lower growth of their economies.
• Focusing on more recent data, during the 42-year period from 1970 through 2011, whether measured in local currency or dollars, the correlation between economic growth and stock returns was effectively zero.
• For 15 emerging markets, during the 24-year period 1988 through 2011, the correlation was -0.41 in local currency and -0.47 when measured in dollar terms. The data for China was particularly compelling: While economic growth in that country averaged about 9%, its stock returns were -5.5% per year.

In his wonderful book, “Expected Returns,” Antti Ilmanen presented the following as evidence on the relationship (or lack of one) between real GDP growth and real stock returns. The following table covers the 22-year period 1988 through 2009.

As further evidence, Ilmanen offered this example: For the period 1993 through 2009, China’s annual real GDP growth rate averaged more than 10%. But a U.S. dollar-based investor would have earned negative nominal returns during that 17-year period. That’s not even accounting for inflation, which ran about 2.5%. While China’s economy grew fivefold, investors lost money.

Summary

The evidence presented demonstrates that differences in GDP growth contain little information about the differences in stock returns in the same year and over the subsequent year as well. This means it is difficult for investors to earn excess returns by relying on estimates of current or future GDP growth—even estimates that perfectly forecast GDP growth over the next 12 months.

Why is the conventional wisdom of investors about economic growth and stock returns so at odds with the data? There are several explanations.

First, there is a general tendency for markets to assign higher price-to-earnings ratios when economic growth is expected to be high, which has the effect of lowering realized returns. Countries that are expected to have strong economic growth can be perceived as safer places to invest. That translates into higher current valuations.

Second, the conventional wisdom fails to account for the fact that the markets price risk, not growth rates. High expected GDP growth rates are already built into a country’s current stock prices. The only advantage would come from being able to forecast surprises in growth rates.

For example, if a country were forecasted to have 6% GDP growth and it actually experienced a growth rate of 7%, you might have had the chance to exploit such information (depending on how much it cost to make the forecasts and how much it costs to execute the strategy).

Unfortunately, there doesn’t seem to be any evidence that the ability to forecast GDP rates is any more reliable than the nonexistent ability to accurately forecast the markets.

Third, while economic growth is good for people (it produces not only a higher standard of living, but residents of countries with higher incomes have longer life spans and lower infant mortality rates), equity investors will not necessarily benefit. For example, a country can grow rapidly by applying more capital and labor without the owners of capital earning higher returns. And productivity gains can show up in higher real wages instead of increased profits.

Klement noted in his findings that the lack of a relationship between GDP growth and stock returns appears in very stark contrast to the strong positive correlation between valuation measures (such as the CAPE 10) and real stock returns.

The conclusion we can draw is that stock returns are predominantly driven by valuations, not economic growth. Investors seem to price-in future growth and reflect it in current valuations, no matter whether one looks at large, medium or small enterprises.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.