Can economic growth hurt investors?

Brian Sturgess - July 2013


Speed Read
  • Fast growing countries sound attractive to investors, but may not produce good returns.
  • In China despite real GDP per capita growth of 9.4% per annum between 1993 and 2011 investors earned a negative annual return of 5.5%.
  • Evidence across a large sample of 36 developed and emerging countries finds that the average relationship between equity returns and real GDP per capita growth is consistently negative.
  • Cross-country studies suffer by mixing rich and poor countries. There are major differences between largely developed and undeveloped markets which affect stock market returns.


Why investors seek growth

In theory a fast growing countries like China should produce good equity market returns for investors. In practice, they do not seem to do this consistently. In China, for example, whose stock market only opened in 1990, despite average annual real growth in GDP per capita of 9.4% between 1993 and 2011 equity market investors earned a mean negative return of minus 5.5%. Similarly, in Russia over a slightly shorter period 1995-2011 mean equity returns were minus 2.2% despite positive real growth in GDP per capita of 3.6% per annum.

 

GDP and Equity Returns: The Evidence

Support for the proposition of an overall negative relationship between equity returns and GDP growth was based on evidence presented in the book Triumph of the Optimists by Dimson, Marsh & Staunton (2001). The authors found a negative correlation between real stock returns and real per capita economic growth for countries with continuously operating stock markets over the period 1900-2001. [1] The results are robust irrespective of the time horizon over which this relationship is measured and whether or not the sample of countries is split into developed and emerging markets.

Similarly, a more recent study by Jay Ritter based on an extension of the same database found that for 21 developed countries over the period 1970-2011 the cross-sectional correlation between returns and the growth rate of per capita gross domestic product (GDP) was also negative with a value of minus (-0.04). For a sample of 15 emerging markets from 1988-2011, [2] the negative correlation between returns and growth was much stronger calculated at minus (-0.49). Ritter’s data is presented for the developed markets in Chart 1 and for the emerging markets in Chart 2.

 




But there is a clear distinction between rich and poor countries. In many developed markets the positive relationship between equity returns and growth rates holds and, if anything, the real return on equities has been greater than the growth in real living standards over long periods. In the US and Germany, for example, between 1970-2011, while real GDP per capita grew by an average rate of 1.85% and 1.78% respectively, the mean real return on equities in local currency was 6.2% and 2.9%.

The large cross country studies cited above concentrate only on correlations between averages, but they ignore the impact of institutional factors such as shareholder protection, corruption and the misdirection of capital by the state. The problems facing shareholders in Russia and China among other countries in these areas are well documented. In contrast, a smaller selection of 10 countries from the same database consisting of Germany, the main Anglo-Saxon economies[3] and Scandinavia[4] exhibit a positive correlation of 0.33 between real equity returns and GDP growth over the period 1970-2011. These countries were chosen by the author for their strong legal systems and institutions.

 

Explaining the evidence

Equity returns are determined by prospective earnings and GDP data is historic so the lack of a clear relationship between the two variables is understandable. There are a number of other reasons why there may be a divergence between domestic GDP growth and the returns earned by companies listed on a national exchange. One important factor is the proportion of earnings accounted for by foreign earnings. The equity returns to investors in Nestle would not be expected to be related in any meaningful way to Swiss GDP. Similarly, the international exposure by S&P listed companies would imply a relationship between stock market value and the growth in GDP of countries outside the US. A study by Gruber (2012) based on an analysis of 754 US based multinational companies found that their foreign income share increased by 14 percentage points between 1996 and 2004.


But it is not easy to explain the negative relationship observed between the real return on equities and rises in living standards in the cross-country studies.  Ritter (2012) explains the result by arguing that stock returns are determined not by growth in economy-wide earnings, but by the growth in earnings per share. In contrast, rapid economic growth requires a rise in investment and in many cases managers overinvest, that is “take on projects that fail to earn their cost of capital—because of their habitual or instinctive tendency to emphasize what can go right while downplaying potential downsides.”[5] Although higher capital investment by companies means higher growth rates for national economies it does not necessarily mean higher returns to shareholders over the longer term. Furthermore, if a company needs to raise equity capital to fund investment, earnings will be diluted. Ritter also argues that much of the benefits of economic growth arising from technological progress accrue mainly to consumers in the form of lower prices and higher-quality products. Investors gain less as competition between companies limits the ability to boost profit margins when costs decline.


There is little sense in investors assessing the relationship between GDP growth and equity returns by using large cross-country studies which mix the unmixable. A forecast of strong GDP growth should not then be an investment signal for a country’s stock market without taking into account many other factors. Caveat emptor applies. The safest returns are offered in richer countries with strong institutions, poorer countries remain for the adventurous. 

 

References

Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, 2002, Princeton University Press, Princeton.

Gruber, H. (2012), Foreign Taxes And The Growing Share of US Multinational Company Income Abroad: Profits, Not Sales Are Being Globalized, Office of Tax Analysis, Working Paper 103, February.

Jay R. Ritter, Economic growth and equity returns, Journal of Applied Corporate  Finance, Volume 24, No. 3, Summer, pp8-18.



[1] Since the publication of their book, Dimson, Marsh, and Staunton have presented extensive additional analysis of the negative correlation for additional countries and other time periods in their 2005 and 2010 Yearbooks

[2] For China, India and Brazil the calculations cover the period 1993 to 2011 while for Russia the period covered is 1995 to 2011.

[3] These are the USA, Canada, the UK, Australia and New Zealand.

[4] These are Denmark, Finland, Norway and Sweden.

[5] Ritter (2012) p.14