Will economic growth drive investment returns?

There will be investors who have been seduced back into stockmarkets this year by the prospect of stronger economic growth.

Improving economic conditions should, by rights, mean an easier environment in which to generate corporate profits, and therefore improving share prices. But as this year has shown, and history will validate, stockmarket growth and economic growth have at best a tenuous relationship.

At the start of 2014, there was an assumption among asset allocators that an improving economic backdrop should mean a better environment for stockmarkets. This sounds intuitively right. If people have more money to spend, some of that is likely to find its way into profits growth for companies and lead to stock price appreciation. The idea that stockmarkets do well when economies do well is common currency among investors.

Bad assumptions

A number of people have disputed this idea, however. The first was economist John Maynard Keynes back in the first half of the 20th century, who believed stockmarkets were little more than giant casinos, in thrall to animal spirits, rather than being governed by a rational examination of corporate earnings and profitability. As such, stockmarkets were not directed by metrics such as economic growth, but by emotions.

Anecdotally, it is possible to find examples of this in practice. Perhaps the most notable recent example is in China, where the economy has grown steadily at 8.2-8.5% for the past three years. At the same time, the FTSE Xinhua index has fallen 44% since February 2011.

Academic research also supports only a weak correlation between economic growth and stockmarket performance. In the Vanguard White Paper, The Outlook for Emerging Market Stocks in a Lower Growth World, the passive fund specialist group says: "We find that the average cross country correlation between long-run GDP growth and long-run stock returns has been effectively zero."

Vanguard pinpoints four factors to explain this seemingly counter-intuitive result. "Consensus growth expectations are already priced into equity valuations; GDP growth may not be a good proxy for earnings growth in a world of multinational companies; much of the market capitalisation growth in emerging markets comes from share issuance rather than rising stock prices; valuation, or the price paid for earnings growth, is a more important driver of returns than economic growth."

Anticipating a revival

The study may have been carried out on emerging markets, but similar conclusions could be drawn globally. As Vanguard points out, markets anticipate rather than reflect economic growth. Jan Luthman, part of the macro-thematic team at Liontrust, says: "Markets tend to get ahead of themselves. When recovery materialises, it can be a little 'ho hum, we'd already seen that coming'. There is nothing more to anticipate." If prices have already risen, investors are unlikely to make significant returns, no matter how strong the economic growth, which leads to Vanguard's conclusion above on valuation.

For investors this is tricky. This means they have to anticipate an economic revival before markets do, and get in while share prices are still low. This is no mean feat. The best economic forecasters with all the tools at their disposal have a relatively weak record of accuracy when predicting economic growth, and forecasts are often subject to revisions. The chance of predicting changes in market conditions as a private investor is even smaller.

The second factor is that stockmarkets do not necessarily reflect the domestic economy. There are companies listed in the UK that generate no domestic earnings at all - mining stock Kazakhmys, for example. Luthman says: "The stockmarket doesn't represent the domestic economy in which companies are housed. In the FTSE 100, 80% of the earnings don't come from the UK and therefore growth is driven much more by global events than by domestic events. The same is true in emerging markets - the earnings are global and not in emerging markets."

The problem is particularly acute for larger companies, which may operate in numerous countries. He adds: "As fund managers, we have become more adept at knowing where earnings are generated. Most companies give a breakdown in a statement, and that has become a natural part of the investment decision process."

Equally, economic growth is only ever one part of the picture. For example, as UK economic growth picks up there has been a resurgence in consumer spending, but for retailers there are lots of other things involved, such as the growth of the internet. That said, while an improving economic outlook is not a guarantee of higher stockmarket returns, economic indicators can be informative in different ways.

Mark Page, manager of the Artemis European Opportunities fund, says: "People will say that the macroeconomic and stockmarket sides are not correlated, but it does matter. It is about what the market expects and what it gets. In Europe, for example, there will be an effect from the fact that Greece is going to be a lot better than last year."

Crises do matter

As any European manager will testify after the experience of the past few years, crises matter. The best, most global company in Greece could not transcend the fact it was domiciled in Greece during the height of the credit crisis.

More recently, the MSCI Turkey index sold off by 14.8% over the three months to the end of February, as investors started to reassess the country's high external debt. Few companies, even those with external earnings, proved immune. The index may have been hit harder because of the higher weighting in financials - a lot of the major constituents are banks.

Emerging market banks tend to be more exposed to their domestic economy. Page says: "Turkey is very dependent on foreign borrowing. The market now looks very cheap, but we don't like what is going on politically." So, avoiding countries in crisis is one important means of using economic data to invest more wisely.

There is also a relationship between a country's bond yield and the rate at which domestic companies can borrow. If a country's rate of borrowing is high - as it was for many peripheral European countries at the height of the credit crisis - it affects the amount corporates pay for debt. If borrowing is more expensive, it makes it harder to grow a business.

Barry Norris, manager of the Argonaut European Alpha funds, gives the example of peripheral Europe: "The problem was that for a long time money was not available in these countries. The price of debt is priced off the government rate, and when that comes down borrowing becomes easier."

"The stockmarket doesn't represent the domestic economy"Jan Luthman

Norris believes that it is possible to draw relationships between economic and stockmarket growth, but not in the way that many people think. "It is the change in economic growth that is really influential on stockmarkets," he says. "Chinese growth moving from 10 to 7% was considered a slowdown.

"In the same way, Greek growth moving from -6 to +1% is considered an expansion." In particular, he says, there is potential for investors to make higher returns in the period when an economy is moving from bad to less bad. Finding changes in trend is more important than absolute levels of growth.

West LB Mellon Asset Management chief economist Holger Sandte argues that the relationship between stockmarket growth and economic growth is actually the other way round. Strong stockmarket performance can lead to economic growth. He also argues that as share ownership has become more widespread, this influence has increased.

This is not purely a confidence factor. Companies rely on the stockmarket for financing, and if stockmarkets are weak, they cannot raise money for expansion. This means they cannot hire new people, or invest to grow the business. In turn, this will have an impact on wider economic growth.

Sandte's conclusion is dramatic, advising investors to "relinquish any hopes of finding a single economic indicator that will predict future market developments early and reliably. As counter-intuitive as it may seem, data suggest that high growth rates do not necessarily correlate with the higher long-term stockmarket returns."

Certainly, the relationship between stockmarket growth and economic growth is not as straightforward as "economies improve therefore stockmarkets rise", and you should be wary of investing on that basis. Investors need to be careful how they treat economic data. Changes of direction are likely to be far more important than absolute levels of growth.