Even my most successful clients worry that a “prolonged recessionary environment” or “low growth economy” or “staggering debt levels” will de-rail their financial plans. Oftentimes, they are surprised to learn that neither government debt levels nor GDP growth correlate with equity market returns so I spend a lot of time on this topic.
By comparing a country’s GDP growth to its equity market performance, we can test the correlation. This analysis was conducted using all the developed countries in the MSCI universe, divided each year into three “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-, medium-, and low-growth countries.
The graph below illustrates this relationship in terms of a dollar invested in these three GDP growth portfolios from 1970 to 2010. For most of the sample, a dollar invested in the high-growth countries underperformed a dollar invested in either the low-growth or medium-growth countries. It was not until the last two years of the sample that the high-growth countries pulled ahead of the low-growth countries. An investor would have seen his or her investment grow the fastest in the medium-growth countries. This highlights the result that GDP growth and equity returns do not have a one-to-one relationship.
Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns. Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses, and private investments.
Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market. Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth. This is another great example of how difficult if not impossible it is to translate your outlook for the economy into a thoughtful investment strategy.