The Growth Paradox: Past Economic Growth Does Not Predict Future Stock Market Returns

EMERGING stockmarkets go in and out of fashion. They were battered during the Asian and Russian crises of the late 1990s, but then recovered to offer double-digit annual returns in the first decade of the 21st century. Since 2010, however, they have reverted to underperforming their developed-country rivals.

The arguments in favour of investing in emerging markets are the same as they ever were. Such countries have faster growth, on average, than the rich world and a smaller weight in global equity indices than they do in the world’s GDP.

But as Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School have pointed out in the past, there is no automatic link between economic growth per person and stockmarket returns. In their latest report for Credit Suisse, a bank, the academics explore this issue in more detail.

They find one slightly odd distinction: the correlation between equity returns and economic growth per person since 1900 has been negative, but that between equity returns and aggregate GDP growth is actually positive. A growing population, in other words, is better for equities than a richer one.

This relationship is, alas, not very useful for investors. Let us assume that they make forecasts of economic growth by extrapolation from the data for the previous five years, and put money in the equity markets of the countries that have grown the fastest. Since 1972, that approach would have delivered a return of 14.5% a year in dollar terms. But had they invested in the economies with the slowest growth record, investors would have earned 24.6% (see chart).

This may partly be down to a “value” effect, similar to that observed with individual stocks. Countries with good growth records become favoured by investors who bid up share prices accordingly; future equity returns are thus lower. But countries with poor growth records see their stockmarkets shunned; their share prices are thus cheap and offer higher subsequent returns.

Another problem is that extrapolating from past economic growth simply doesn’t work. The report finds no correlation since 1900 between GDP growth per person in an individual country in one year and growth two years later.

Furthermore, a stockmarket is not a perfect representation of the domestic economy; successful companies may be privately owned and not listed on the market while many big companies (as in China) may be owned by the state. As they grow, companies issue more shares; as a result, existing shareholders do not gain all the benefits of higher profits.

Over the long term, these dilution effects mean that investors do not get all the benefits of GDP growth, in the sense that dividends grow more slowly than the economy. Between 1900 and 2013, real dividends declined slightly (0.1% a year) over the 21 countries for which the academics have data, while GDP growth was 2.8% a year. Even in America, the most successful economy over the period, real dividends grew by 1.6% while GDP growth was 3.4%.

The report does find that prior knowledge of GDP growth would be useful. If investors had had perfect foresight of which economies would grow fastest over the following five years, and had invested accordingly, they could have earned 28.8% a year. Then again, if the fates were to grant investors perfect foresight, it would be simpler for them to be aware of the best performing markets, not the best economies.

In the absence of such powers, emerging markets still have their attractions. The academics reconstruct an emerging-market universe going back to 1900 using a definition based on GDP per head; starting with a group of seven (China, Finland, Japan, Portugal, Russia, South Africa and Spain). Over the extended period, emerging markets underperformed, returning 7.4% versus 8.3% for the developed world.

However, the biggest period of underperformance was in the 1940s, when Japanese equities lost 98% of their dollar value and the Chinese market disappeared in the revolution. Since 1950, emerging markets have returned 12.5% a year against the developed markets’ 10.8%. This is the right result, in theory: emerging markets are riskier (in the sense of being more volatile) and so investors should demand a higher return.

The good news is that volatility has declined over time, both in absolute terms and relative to developed markets. The bad news is that, in the five years to the end of 2013, the correlation between emerging markets and their developed brethren was twice as strong as it was in the early 1990s. Globalisation has integrated developing stockmarkets as well as their economies.

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