Swedroe: High Growth Countries No Sure Thing

June 17, 2015

Conventional wisdom can be defined as ideas so ingrained in our belief system that they are accepted without challenge. Unfortunately, much of the conventional wisdom about investing is incorrect.

For example, the conventional wisdom that investors seeking high returns should invest in countries forecasted to produce high rates of economic growth—such as India and China—is simply wrong.

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 that knowledge and earn abnormal returns.

Relying on intuition, however, often leads to erroneous conclusions. In this case, the conclusion that you should look for investment opportunities in countries with high forecasted rates of economic growth is false, because it fails to account for the fact that markets are highly efficient at building information about future prospects into current prices.

Two Types Of Information

In short, investors fail to understand the difference between information and value-relevant information. The historical evidence on the correlation of country economic growth rates and stock returns demonstrates this point.

The latest contribution to the literature on this issue is from Joachim Klement, author of the study “What’s Growth Got to Do With It? Equity Returns and Economic Growth,” which appears in the summer 2015 issue of The Journal of Investing. Using MSCI country indexes, Klement investigated the equity market returns of 22 emerging and 22 developed markets for large-cap, midcap and small-cap stocks. Prior research, which we’ll also review, had examined only large-cap indexes.

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

GDP vs. Equity Market Returns

Klement found 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 also 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.

 

 

Global Growth Vs. Equity Returns

Because 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 explored the relationship between global growth and stock returns. While he did indeed 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 growth of productivity as well as input factors like labor and capital. Thus, real earnings growth may be higher even when GDP per capital 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.

Historical Evidence

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 that had continuously operating stock markets during the 112-year period from 1900 through 2011, the correlation between stock 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, the correlation between economic growth and stock returns was effectively zero, whether it was measured in local currency or in dollars.
  • For 15 emerging markets, during the 24-year period from 1988 through 2011, the correlation between economic growth and stock returns was -0.41 in local currency and -0.47 when measured in dollars. The data for China was particularly compelling: While economic growth in that country averaged about 9 percent, its stock returns were -5.5 percent 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 from 1988 through 2009.

 

  Real GDP Growth (%) Real Equity Return (%)
United States 2.6 6.6
Japan 1.6 -3.3
Europe 2.0 6.4
Asia ex-Japan 6.4 6.9
Latin America 2.8 18.8

 

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

 

 

What If You Knew The Fastest-Growing Countries?

 In a study from 2006, “Economic Growth and Emerging Market Returns,” Jim Davis of Dimensional Fund Advisors chose to examine emerging market countries because of the widely held perception that emerging markets are inefficient. Davis’ examination of the relationship between country GDP growth rates and stock returns covered the period 1990 through 2005.

At the beginning of each year, Davis divided emerging market countries found in the IFC Investable Universe database into two groups, based on GDP growth. The high-growth group was made up of the 50 percent of the countries with the highest real GDP growth for the upcoming year; the low-growth countries made up the other half.

He then measured returns using two sets of country weights: aggregate free-float-adjusted market-cap weights and equal weights. Companies were market-cap-weighted within countries. The results are shown in the table below. 

1990-2005
  Market-Weighted Countries
Avg. Annual Return (%)
Equally Weighted Countries
Avg. Annual Return (%)
High-Growth Countries 16.4 22.6
Low-Growth Countries 16.4 21.5

 

It seems that there is not much, if any, advantage to knowing in advance which countries will have the highest rates of GDP growth. The conclusion we can draw is that emerging markets are very much like the rest of the world’s capital markets and do an excellent job of reflecting economic growth into stock prices.         

Summary

Why is the conventional wisdom of investors so at odds with the data? There are several explanations.

The first is that there’s a general tendency for markets to assign higher price-to-earnings (P/E) 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.

Markets Price Risk

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

For example, if a country was forecasted to have 6 percent growth in GDP and it actually experienced a growth rate of 7 percent, 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 the ability to forecast GDP rates is any more reliable than the nonexistent ability to accurately forecast the markets.

 

 

Why Growth Doesn’t Benefit Investors

Third, while economic growth is good for people (it produces not only a higher standard of living, but the residents of countries with higher incomes have longer life spans and lower infant mortality), equity investors don’t necessarily benefit.

For example, a country can grow rapidly through the application of more capital and labor without the owners of that capital earning higher returns. And productivity gains can show up in higher real wages instead of increased profits.

Valuations Drive Price, Not Growth

Klement noted in his findings that the lack of correlation 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.

 

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