Can economic growth hurt investors?
- 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.
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.
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. 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
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, 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.
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%.
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 and Scandinavia 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.
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.” 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.
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.
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
R. Ritter, Economic growth and equity returns, Journal of Applied Corporate Finance,
Volume 24, No. 3, Summer, pp8-18.