The siren call of GDP growth

National GDP growth matter less than we think it should

Justin Reynolds


The investment press – as ever – is a blaze with speculation about the relative prospects of the world’s economies. Will India’s boom continue? Is the US overheating? Is the UK economy due to shine? Will China recover?

It makes intuitive sense. If you want higher returns invest in those countries expected to grow fastest. Chinese markets have seen periods of spectacular growth over the past 20years as the Republic’s economic power has become apparent. And India’s BSE Sensex is up nearly 90% over the past five years as its economy has become the third-largest in the world, growing by 6% over the past decade.India seems set fair for further sustained growth.

With 1.4 billion people it now has the biggest population in the world, with an average age 10 years below China’s. Economic participation is rising as hundreds of millions gain access to education, healthcare and finance – the proportion of adults with a bank account rose from 35% in 2011 to al-most 77% in 2021. Though the state has invested heavily in infrastructure, India’s growth has been less dependent on government spending than China’s.

Its debt-to-GDP ratio is less than half that of the Asian giant, and much of the investment planned by India’s top companies is earmarked for semiconductors, solar cells and EV batteries. And for all Prime Minister Narendra Modi’s rhetoric, India is keener to cultivate its trading ties with Europe and North American than Xi Jinping’s China.

Indian markets already have a forward P/E ratio of 23, but they continue to lag cumulative earnings growth of 31%, suggesting the possibility of a re-rating if the country’s current wave of growth is accepted as structural rather than cyclical. Higher GDP does not equal higher returns but it is that concern for valuation, rather than headline growth, that is so easy for everyday investors to overlook. Because the plain historical evidence is that higher national GDP is no guarantee of higher market returns.

A 2022 study by Jason Hsu, Jay Ritter, Phil-lip Wool and Yanxiang Zhao published in The Journal of Portfolio Management, examining data from 15 emerging and 21 developed equity markets going back 120 years, found marginal correlations of 0.17 and -0.31 be-tween per capita GDP growth and stock re-turns in developed and emerging markets.

The research followed work 10 years earlier by Ritter concluding that from 1970 through 2011 the correlation between economic growth and stock returns was effectively zero. Indeed tracing the figures back 1900indicated investors would have been better off investing in the companies of countries with lower GDP growth.

Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton’s epic history of the markets, published in 2002, found a negative correlation between national per capita economic growth and stock returns.Meanwhile, Antti Ilmanen’s 2011 book Expected Returns, focusing on China, observed that while the world’s largest economy grew fivefold from 1993 to 2009, a US dollar-based investor would have earned negative nominal returns.

Though Chinese economic growth averaged around 9% its relative stock return worked out at -5.5% per year. In brief, markets price risk, not growth rates. Stock returns are driven by valuation,as highlighted by the 2022 study, which re-ported a notable 0.5 correlation of real stock returns with real EPS growth.

If expectations of high growth are priced into a national market’s stock prices, investors will not benefit. A booming market may indicate confidence in future growth, but the reverse is not true either.Indeed growth can obscure fundamental economic issues, as investors have so often learned to their cost when betting on fast-growing economies.

It gets ever harder to grow over time – it is easier to build factories employing cheap labour than invest in productive technologies and workflows. Companies can expand rapidly by applying more capital and labour without owners earning higher returns – productivity gains can show up in higher real wages instead of increased profits.

And growth does not benefit listed or domestic companies. Though Ireland’s economy grew rapidly through the1990s and 2000s its stock market produced weak returns, its low tax regime attracting foreign firms that stayed private.

Diversification, again

So if valuation matters more than growth, or, more precisely, the market’s expectations of value, where should time and knowledge limited ordinary investors put their money to benefit from economic dynamism?The answer is rather duller, perhaps, than taking outsized stakes on the headline performance of one or two high-flying national economies.

Diversified global trackers dilute returns but at least guarantee investors expo-sure to whichever national index has caught the market’s eye. Consider the oscillations between emerging markets, European and US stocks over the past 20 years. Portfolios must encompass unloved markets that may– sooner or later – generate returns.

Today’s UK and Japanese markets are a casein point. As the Bank of England’s continued agonies over interest rates testify the outlook for the UK’s economy is still mixed. But with a P/E ratio of 14, the FTSE 100 is one of the cheapest developed markets in the world.

This year, the market has noticed, the index passing 8,000 for the first time, up 9% this year.Japan’s Nikkei 225 is another unlikely success story, emerging from the shadows after more than three decades of indifferent performance to rise by a third over the past 12 months, finally passing the level it last reached in 1989.

The deflation that has haunted the economy – a combination of flat inflation, interest rates and wage growth –may finally be coming to an end, and a virtuous cycle between rising wages and prices emerging. Earlier this year the Bank of Japan felt able to raise borrowing costs for the first time since 2007.

A raft of stock market reforms have helped, challenging the long-time relative indifference of Japanese listed companies to shareholder interests. Mergers and acquisitions are becoming more commonplace, and as prices rise many Japanese savers are looking to the stock market as a store of value.

The Nikkei 225’s gains have come despite continued sluggish economic growth. Though Japan remains a technological and industrial powerhouse, the presence of China, Russia and North Korea as close neighbours, and the threat of protectionism from an incoming Trump administration weigh on the country’s economic prospects.

It has been said that Japan and China are reversing the positions they have held for the past 30 years – just as China began to rise as Japan fell, so Japan is rising as China falls. That is too neat. Certainly, Chinese markets have had a rough time, down more than 60% from their 2021 peak.

Growth has disappointed, there is an unresolved property sector crisis,government support for markets has under-whelmed, and diplomatic relations between Beijing and Washington are fraying.But a case can be made that Chinese stocks are now trading at a significant discount. Wall Feature Street is signalling new interest, with JP Morgan forecasting the MSCI China index will rise by more than 30% this year while hedge funds are building exposure.

As always, uncertainty

The truth is we do not know what will hap-pen. China’s trade conflict with the US may deteriorate further. Worse, there is the possibility of actual war in the Taiwan Strait. Japan’s exit from deflation may prove illusory.

Courted by Russia and China, India’s loyalties are uncertain. Its still land-based economy is particularly vulnerable to climate change. The UK may be set for a period of stability under a new government. Or not. US markets may or may not fly under Trump, as they did last time.

Investors might be well advised to hold a stake in all these markets rather than guessing which one might outperform. They should be wary of relying on GDP expectations, which are only of advantage if forecasts of outsized growth come true. But it would perhaps not be overly disrespectful to suggest economists’capacities to foresee GDP are no more reliable than those of financial commentators to read the markets.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.


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