GDP and its relationship with broader markets

It is generally believed that economic growth is good for the stock returns. This belief holds that there is a positive correlation relation between the real economy and capital markets. Therefore it should make sense to invest in stocks of countries where the economy is stable and which has strong growth prospects.

However, there is no agreement on whether it is the real economy that influences the capital market or the other way round. For example, one can argue that with rising stock price, firm finds easier to raise equity for business expansion. This leads to additional investment in the economy and therefore improves economic activity. Rise in stock prices can also bring about a wealth effect, which increases consumption. On the other side, one can argue that investors react positively to the data released on macro economy or information about economic policies pursued by the state or even track earning performance of listed companies.

But if one were to hold this general belief that economic growth is good for stock markets, than by extension, investors should prefer to invest in countries where long term growth outlook is strong. However, when we take the example of China between CY08 to CY17, the country registered 8.2% GDP CAGR (real), but during the same period Shanghai Shenzhen CSI 300 Index was down 24.5%. Following table shows nominal GDP CAGR (in USD) of select four counties and their respective equity market performance (in USD).

Data Source; Axis Securities and Bloomberg

Empirical research done on this subject by Jay Ritter, professor at the University of Florida, does not confirm this instinctive connection and suggests that in the long run there has been a negative correlation between economic growth and stock market return in developed as well as in emerging markets. His analysis ran from 1900 through 2011 for developed-markets countries, and 1988 through 2011 for emerging-markets countries. [Just to recap a correlation between variables, closer to a magnitude of 1 means GDP and market returns have a strong relationship; if positive then they move together and negative when they move in opposite directions. Closer to 0 indicates that there is little correlation between the two variables]. A similar study was done by Jeremy Siegel, Professor of Finance at Wharton School, for the time series between 1970 and 1997, in which he compared the stock returns and economic growth among the developed countries. In his study he found that except for Singapore, over the past 27 years there has been a negative correlation between economic growth and dollar stock returns.

When we looked at the correlation of the real return (annual series INR yoy returns) on the Sensex and India’s real GDP growth, from CY 1991 to CY 2018, we obtained a Correlation Coefficient(R) of 0.2 which shows low correlation. (As data prior to 1991 was not available our study covers only this 3-decade period)

Data Source; Anand Rathi Securities

So there seems to be no clear connection between economic growth and market returns. The following explanation may throw some light on this relationship

The correlation may be weak when investors have high hopes for the future economic situation, which happens particularly often in periods of fast growth. When growth expectations are very high, investors are so eager to participate in the expected profits of such growth that they largely ignore the price they pay to do so. This attitude leads to overpriced stocks and consequently to low rates of return in the future. For example China registered real GDP growth of 11.6% CAGR between CY02 to CY07, and in end Dec 2007 Shanghai Shenzhen CSI 300 Index P/E was at 42x. A phase of high growth with high expectation resulting in investors willing to pay a higher P/E. However a decade later, China real GDP growth in CY17 decelerated to 6.8% and Index P/E was at 16.5x. This resulted in investor’s wealth erosion of 24.5%.

Data Source; Axis Securities and Bloomberg

According to Prof. Siegel, one reason for rates of return on equity not to follow GDP growth may be progressing globalisation and the fact that multinational corporations play an increasingly important role in the economies. In other words, many corporations derive a good chunk of their profits from international operations, which are not dependent on domestic operations. For example, performance of Tata Motors is exposed to operations of JLR, its 100% subsidiary, which has of operations outside India. Its profit forms a large part of the profit pool for the parent. In this case JLR’s operations outside India will not add to the Indian economy, but its profit contribution would impact Tata Motor’s share price.
As per Jay Ritter, negative correlation also exists because stock returns are determined by improving values of the selected measures of corporations’ performance like P/E and ROE which reflect both i) earnings and ii) the amount of capital contributed by investors, and not by the profits corporations generate in the economy. Therefore if continuous growth is one of the objectives of the firm, it might as well be achieved through reinvestments into negative NPV projects which then achieves economic growth but may not be value-accretive to shareholders.
In theory, technology along with land, labour, capital and enterprise contributes to the growth in the economy. However, Warren Buffet (in 1999) argued that in the long run in a competitive economy, benefits from changes in technology accrue to the consumer and not necessary to the shareholders. He cites examples of car makers, manufacturers of radio, television and aircraft, where the industry have grown apace and have contributed to the economy but investor returns are poor. According to him it is important to pay attention to the competitive advantage of any given company and above all the durability of that advantage. In the Indian context, the Telecom sector serves as an illustrative example of this dichotomy.

Data Source; Ace Equity

As seen in the table above, the telecom sector has underperformed nominal GDP growth in the last ten years despite improvement in penetration and improvement in technology. This is a reflection of the fact that the benefit of improved technology was garnered more by consumers and little accrued to companies due to intense competition.

We are not arguing that countries that experience economic growth above expectations will not experience higher returns. But we would also like to caution against the opposite view, that higher economic growth is a sufficient condition for superior stock market returns. Ultimately for the investors to make superior returns due attention has to be paid to underlying cash flows which business can generate over long period of time, sustainable return ratios of the business and what price one pays to acquire the business.

Glossary:

GDP: Gross Domestic Product

CY: Calendar Year

CAGR: Compound Annualized Growth Rate

USD: United States Dollar

INR: Indian Rupee

P/E: Price to Equity

RoE: Return on Equity

NPV: Net Present Value

JLR: Jaguar Land Rover

Disclaimer

Inference from one sector need not be reflective of the entire economy.