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November 2016
 |
Economic
Growth (The Total
Investment & Insurance Solutions)
By 2050 the world's
population is projected to reach 9.7 billion, up from 7.4 billion today. Nearly
all of that growth will come from emerging markets, where living standards are
rapidly improving.
Although these markets have
experienced large capital inflows, they still have a long way to go to match
developed countries' levels of capital, productivity, and wages. Consequently,
emerging markets will likely continue to grow faster than developed markets for
the foreseeable future. While this growth may lift hundreds of millions out of
poverty and spur investment and innovation, evidence suggests investors may be
left behind. The Total Investment
& Insurance Solutions
Jay Ritter, a professor at the University of
Florida, documented a negative relationship between economic growth and stock
market returns in his seminal research paper, "Economic Growth
and Equity Returns," published in 2005. Ritter's findings are
no fluke. The Total Investment &
Insurance Solutions
Using
real gross domestic product data from the World Bank and the gross return
version of each market's MSCI country index, I found a weak negative
correlation between GDP growth and stock market returns across 41 countries
from 1988 to 2015 (data for seven of these countries--China, Colombia, India,
Israel, Peru, Poland and South Africa--was not available until 1993, while data
on Russia started in 1995). This relationship is plotted in this chart, where each
country represents a separate point. Excluding China--the outlier at the bottom
right of the chart--results in a slightly positive, though still very weak,
correlation between GDP growth and stock market performance.
While the correlation between these two variables may
change a little over time, the findings are fairly robust over long time
horizons. It's clear that higher economic growth does not necessarily translate
into superior stock market returns over the long run. The Total Investment & Insurance Solutions
Reasonable assumptions?
This result should not be surprising given the strong
assumptions that would be required to link GDP growth to stock market returns.
In order for this relationship to hold, publicly traded stocks' valuations and
earnings as a share of GDP would need to remain stable over time. This means
that private and public companies would need to grow at the same rate, and
there could be no new enterprises or IPOs. Second, there could be no dilution
from new share issuance. Finally, all publicly listed companies would need to
generate substantially all of their revenue and profits from the domestic
economy. The Total Investment &
Insurance Solutions
The link between economic growth and
profitability
In a closed economy, it would be reasonable to expect
that corporate profits in aggregate would grow at a similar rate as the economy
in the long run. Although the share of corporate profits relative to GDP
fluctuates over time, it tends to revert to the mean. Profits cannot
persistently grow faster than the economy because they would crowd out all
other economic activity and attract new competitors. Similarly, total corporate
profits should not grow slower than the economy in the long run, as firms exit unprofitable
businesses, allowing those remaining to preserve margins. The Total Investment & Insurance
Solutions
But
most of the world's countries are not closed. The largest companies listed in
most countries tend to be multinational firms that generate a large portion of
revenue and income outside their host country. For instance, in 2014 the
constituents of the S&P 500 generated about 48% of their sales outside the
United States, according to data from S&P Dow Jones indexes. This
international exposure means that profits can grow at a different rate than the
domestic economy, even in the long run.
Even if aggregate corporate profits grow in sync with
GDP, dilution can prevent shareholders from enjoying the benefits of growth.
Creative destruction is essential to economic growth. In aggregate all
companies that are publicly listed today will grow slower than the economy
because new entrants drive much of that growth. Between the time these new
companies are launched and publicly listed, their growth dilutes most
investors' ownership interest in the economy. Flagrant dilution of corporate
earnings through employee stock grants and seasoned offerings is also a very
real risk, particularly in developing countries with a tradition of poor
corporate governance. Additionally, earnings growth can only create value if it
allows firms to generate returns that exceed their cost of capital. High
reinvestment rates may enhance both corporate and domestic economic growth but
destroy shareholders' wealth through inefficient capital allocation. The Total Investment & Insurance
Solutions
Is growth already priced in?
Growth
expectations influence stock market valuations. Valuations are rich when
investors expect strong growth. However, as developing economies mature, their
growth rates slow and valuations tend to decline. Consequently, even when
countries realize their expected growth rates, their stock markets may not keep
pace.
The
impact of lofty growth expectations on valuations can create a treadmill
effect, whereby fast-growing economies must realize high growth in order to
generate a competitive rate of return. For example, in the mid-1980s the
so-called "Asian tigers" had experienced two decades of rapid growth
and investors had high expectations for future growth. In contrast, several
countries in Latin America were facing severe inflation, a debt crisis, and low
expectations for future growth. As a result, in 1986 Latin American stock
markets were trading at 3.5 times earnings, while the Asian markets were
trading at 18.3 times earnings.
Over the subsequent two decades, Latin American stock
markets posted more than twice the annualized returns of the Asian markets,
despite experiencing lower GDP growth over that horizon. Scholars argue that
this was because Latin American countries implemented economic reforms that
allowed them to exceed investors' low expectations. Conversely, the Asian
markets performed in line with investors' high expectations, which were already
priced in. The Total Investment &
Insurance Solutions
What's an investor to do?
In order to benefit from economic growth, investors must
identify markets that have the potential to exceed expectations. Russia may fit
the bill. At the end of September, the Russian equity market, as proxied by VanEck Vectors
Russia ETF (0.67% expense ratio), was trading at a paltry 8.6
times forward earnings, making it the cheapest of any major emerging market.
Corruption, sanctions and a taxing regulatory environment have stunted the
country's growth and depressed valuations. Weak oil and gas prices and
geopolitical risk haven't helped either. However, if (and this is a big if)
Russia adopts structural reforms that investors aren't expecting (and they're
not expecting much), it could offer high returns--albeit with high risk. The Total Investment & Insurance
Solutions
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