Is the stock market a barometer of the economy?
In the world of economics and finance, there is a pervasive belief that the stock market acts as a barometer for the national economy. It's often presumed that an uptick in stock market performance is directly correlated with a boom in Gross Domestic Product (GDP). However, recent observations challenge this notion, proposing a more nuanced relationship that suggests rapid GDP growth does not necessarily equate to high stock market returns. In fact, countries exhibiting swift economic growth have, paradoxically, underperformed in their equity markets.
Recently, a thought-provoking article titled "Why Stocks Underperform in High-Growth Countries," penned by Derek Horstmeyer, a finance professor at George Mason University, sheds light on this complex dynamic. Through various analyses, Horstmeyer discovered that the countries with the fastest GDP growth rates tended to exhibit the lowest returns on their stock markets. Over the last decade, among the seven fastest-growing nations, only one—India—reported positive stock market returns.
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This realization may seem surprising, but it isn't an outlandish revelation. Historical data paints a clear picture of how GDP growth and stock performance are not always aligned. Take China, for instance, which, from 1993 to 2019, boasted the highest GDP growth in the world at approximately 7% per year (inflation-adjusted). During the same timeframe, the authentic return on Chinese stocks hovered merely around 4% annually.
In contrast, other developing nations such as the Philippines, India, Russia, Malaysia, and Thailand experienced modest GDP growth rates of 2% to 5%, yet their stock market returns were often on par with, or even surpassed, those of China. Take Thailand and Malaysia, for example, with respective returns of 5.6% and 5.3% during the same period. Clearly, a trend emerges that warrants further exploration.
The broader implications of this disparity in growth and stock returns extend beyond developing markets; they hold true in advanced economies as well. Research examining data from developed nations between 1900 and 2019 has revealed a lack of correlation between economic growth rates and stock returns. Australia, the U.S., and Sweden, for instance, manifested enviable stock market returns of 6.8%, 6.5%, and 6% respectively, despite their GDP growth rates being comparatively lower than those of countries like Ireland and Japan.
So, what accounts for this intriguing disconnect? If GDP is not the primary driver of stock market performance, what factors come into play? Derek Horstmeyer’s research seeks to uncover the intricate variables influencing this phenomenon.
Unveiling the Discrepancies
Horstmeyer and his team meticulously analyzed 10 years’ worth of monthly return data from MSCI country-specific exchange-traded funds (ETFs) for 34 different nations, including regions in Western Europe, Scandinavia, parts of Asia, and South America, along with the U.S., Canada, and Mexico. All these returns were presented in U.S. dollars to facilitate accurate international comparisons.
In conjunction with this, they extracted each nation’s quarterly real GDP growth rates, adjusted for inflation. This methodological rigor revealed two pivotal conclusions:
Firstly, when reviewing the annualized return rates over the past decade, it became evident that nations boasting the highest GDP growth rates had correspondingly low stock market returns. Remarkably, countries in the top quartile for GDP growth averaged an annualized return of just 0.10%, while those in the lowest quartile fared significantly better with an average return of 3.42%.
Secondly, the volatility in high-growth countries was also noticeably elevated. The annualized volatility for the top GDP growth quartile averaged 24.70%, in comparison to a more stable average of 22.60% for those in the lower quartile.
These striking discrepancies raised essential questions. Horstmeyer speculated on several potential explanations for this phenomenon.
The first suggestion revolves around market expectations. Investors tend to assume that high-growth nations will sustain accelerated growth rates, and if these expectations fall short, stock performance often suffers as a consequence. This notion resonates with an observation from renowned finance professor Jeremy J. Siegel, who noted that despite China's rapid growth over the past three decades, domestic investors have faced subpar returns due to exorbitant stock valuations. In contrast, stocks in Latin American countries frequently priced themselves attractively, rewarding patient, value-oriented investors.
Lastly, a common method employed by these high-growth nations to propel their economies is through currency devaluation—whether intentional or not. This tactic can inflate GDP figures but leads to diminished returns when assessed in dollars. Horstmeyer’s team discovered clear evidence; comparing the MSCI Emerging Markets Index with a currency-hedged version highlighted how currency fluctuations significantly impact equity performance.
For investors, the core takeaway is straightforward: U.S. investors focusing on returns in dollar terms may want to steer clear of high-growth, emerging markets unless effective mechanisms for hedging currency risks are employed.
The Size of the Economy and Stock Market Resilience
Is there a more granular breakdown concerning different countries? A study from Freshwater Investment analyzed global economic trends post-World War II, categorizing nations based on their trajectories of growth. Some transitioned seamlessly from high growth to stable development, while others became ensnared in a middle-income trap or experienced stagnation.
Within this framework, three distinct groups emerged: first, those experiencing a slowdown yet retaining robust stock returns; second, nations where stock returns and economic growth displayed a positive correlation; and lastly, those where stock market returns rebounded post-slowdown but still lagged behind previous high-growth rates.
Countries in the first group included the likes of the United States, Germany, and Japan, all of which transitioned into stable growth phases without experiencing a decline in stock returns. For instance, U.S. stock returns rebounded after economic slowdowns, often exceeding their previous high-growth levels. Similarly, Germany has reported steady stock market returns at around 10% per annum over the past decade.
Meanwhile, the second group exemplified a nuanced relationship between economic growth and stock returns, with nations like Brazil, Mexico, and South Korea displaying a stronger positive correlation. When economic growth declined, stock returns reflected this downturn markedly. Despite some periods where South Korean stocks underperformed, they eventually yielded returns exceeding GDP growth after the economy completed its transition.
The third group showed that while there was a rebound in stock returns following periods of economic slowdown, these returns generally fell short of earlier high-growth levels, as seen in France and the UK.
In summary, examining these three different groups sharpens the understanding of how economic size influences stock market resilience against declining growth rates. Larger economies often enjoy diversified industrial bases and strategic depth that enable them to adapt more effectively during downturns, showcasing stronger risk management capabilities. In contrast, smaller economies may struggle due to a lack of diversification and a higher dependency on external markets.
Conclusion
Ultimately, a critical examination leads us to a fundamental conclusion regarding the intricate relationship between stock market performance and the underlying economy. Rapid growth does not guarantee superior stock market returns. It is crucial for economic growth to translate into tangible corporate profitability and dividend growth for shareholders to witness favorable returns. The complexities of this relationship cannot be overstated; for example, while Apple generates substantial profits, a significant portion of its products is manufactured in China, contributing to Chinese GDP. Additionally, the Japanese economy, despite its lengthy stagnation, supports numerous global enterprises yielding substantial profits.
Thus, the importance of diversifying investments and understanding underlying economic dynamics cannot be overstated. The journey of investing reflects broader economic narratives, where international growth and productivity play pivotal roles in shaping the landscape for future returns.
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