By Alexei Debelov, Head of Equity at Third Rome (strategic partner of Oracle Capital Group in Russia)
At the end of April, the International Monetary Fund slashed its 2014 growth forecast for Russia to 0.2 percent.
In early May, the Organisation for Economic Cooperation and Development made a similar call revising its Russian GDP growth forecast downward to 0.5 percent. Investment professionals the world over are anxiously awaiting the latest quarterly GDP statistics of the largest global economies. In discussions investors often turn to sluggish economic growth to justify their downbeat assessment of the Russian market outlook. We would like to take a closer look at the connection between equity market performance and GDP growth, as well as the importance of economic growth for asset management.
At first glance, the relationship looks straightforward. One would expect a better economy to entail better average situation at the constituents of stock index. Finance textbooks present economic growth as a key driver of stock market growth. The entire Emerg¬ing Markets investment case – which saw years of massive cash inflows before sputtering growth sent investors heading for the exit – was built around the idea of investing in rapid-growth environments. Yet from 1993 to 2011 real stock market returns for growth champion China (+9.4%) were decidedly in the negative territo¬ry (-5.7%). ‘Leisurely’ Brazil and Argentina, while growing just 2-2.5%, offered investors much better returns – 11-13% a year in real terms. Several groups of researchers have come up with their explanations for the discrepancy.
In a research published in February 2014 three London Business School professors Elroy Dimson, Paul Marsh and Mike Staunton explored the relation between GDP growth and equity investment returns. Their analysis is based on more than a century of data (from 1900 onwards) for 21 developed economies. The researchers report some seemingly surprising results: for devel¬oped countries correlation between real return on equity and real per capita GDP is negative (-0.29), i.e. the public’s growing prosperity translates into diminishing expected equity returns. According to Jay R. Ritter from the University of Florida, the situation is similar for developing countries from 1988 with a correlation coefficient of -0.41.
One possible explanation is that average income growth often goes hand in hand with the development of market institutions, increased competition and reduced corporate profit margins, which weigh down on companies’ valuations. To see the point one only needs to look at gasoline retail margins in the highly competitive European market and in the oligopolistic Russia. On the other hand, rapid economic growth and booming incoming investment are a temptation for many to stick a finger in the pie. The capital market attracts both already listed companies and newcomers eager to raise funds in a high-valuation environment caused by high growth rates, thus diluting the returns for existing investors. In his research “The Paradox of Wealth and the End of History Illusion” focusing on emerging markets during periods of rapid growth William J. Bernstein presents statistical evidence that number of shares grows faster than corporate earnings and dividends. This means that the rate of earn¬ings and dividend growth per share would decline when companies engage in active fund raising to finance new growth, which, considering past experi¬ence, may fail to materialise.
The aforementioned Jay R. Ritter also points out that only projects with positive NPV would give a com¬pany’s value a boost. Thus, high rates of GDP and investment growth brought about by state stimulation of industry – as seen in the 1980s in Japan and later in China – or private inves¬tor exuberance often end up destroying value and sending market valuations down to their fair levels.
Dimson, Marsh and Staunton found out that the situation improves when equity price growth is com¬pared to per capita GDP growth not in the same but in the next year – for the United States, for instance, the correlation figure thus leaps from 0.06 to 0.46. It is a reflection of the role played by the equity market which absorbs all economic data and prices that information into share valuations long before it finds its way into company balance sheets and financial statements. But for investors the value of this observation is very limited: to achieve above-market investment returns by factoring in GDP growth one needs to be able to forecast it better than a multitude of market professionals equipped with sophisticated tools and the latest data, whose forecasts are the source for current market pricing. One should also bear in mind that countries that once showed remarkable growth will not necessarily outper¬form in the future – there is virtually no correlation between GDP growth in a given year and two years previously. Moreover, accumulated returns since 1972 in an investment strategy based on picking stocks from countries with the highest rates of growth over the last five years would be nearly half those generated by shares from the worst economic performers.
Summing up the relation between stock market performance and GDP growth we argue that there is no way for it to be used effectively to enhance the investment decision-making process: what would be useful (future growth rates) is not known and what is known (current growth rates) is of no use. This conclusion largely fits with the weak market efficiency hypothesis: it is unlikely that anyone would be able to uncover such easily extractable value in such a visible and openly available measure as GDP growth rate. At the same time, investors will feel more comfortable knowing that they do not need to waste time and energy monitoring the macroeconomic situation and can instead concentrate on their core task – analysing specific companies and their securities. One can always build up a high-growth portfolio in a stagnating market if he really wants to.
