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.
I get to see how a lot of investors make asset allocation decisions in their portfolios before they become clients of mine. When I ask what the strategy is around determining what is an appropriate exposure to international equity markets, the most common responses include choosing a particular country based on a nation’s gross domestic product, population, trade balances, or some other economic or political data points.
“Given what’s going on in Europe, I’ve reduced my exposure there”
“I’m very concerned about the US debt situation and so am investing more internationally”
“I’ve weighted my international exposure toward Asia. The population and GDP are compelling”
There is a more thoughtful way to view the universe of equity investment opportunities across the globe. The cartogram below depicts the world not according to land mass, but by the size of each country’s stock market relative to the world’s total market value. Viewing the world map by relative market capitalization illustrates the importance of building a globally diversified portfolio and avoiding the biases that may arise from attention to other economic statistics.
If markets are efficient (and if you are a client of mine you know that I believe they are), global capital will migrate to destinations offering the most attractive risk-adjusted expected returns. Therefore, the relative size and growth of capital markets may help in assessing the political, economic, and financial forces at work in countries—but not necessarily the other way around. It would be very difficult to assess economic or political fundamentals of a country and factor that into how much of your capital should be allocated to it without inaccuracies and distortions. This chart brings into sharp focus the investible opportunity of each country relative to the rest of the world.
By focusing on an investment metric rather than on economic reports, we apply a disciplined, strategic approach to global asset allocation. Of course, the investment world is in motion, and these proportions will change over time as capital flows to markets offering the most attractive returns. And we will adjust our portfolios accordingly.
I am delighted to announce the release results of the Family Wealth Advisors Council (FWAC) 2011 Women of Wealth study, a project that has consumed my life for the past 9 months. The study is one of the largest ever undertaken on affluent women. More than 550 successful women from across 44 states weighted in on what they want from their financial advisor, how happy they are with that relationship, and what they worry about as they look to the future. The results may surprise you . . . .