Many investors make the mistake of assuming rapid GDP growth translates directly into positive stock market performance. But the facts point to a very different conclusion. In this article, we want to dissect the role of GDP growth in influencing stock market returns by drawing on some well-known academic literature. We will also bridge the gap between the end dates of these studies and today to see if these conclusions still ring true.
The Body of Evidence
Intuitively, it would seem that rapid GDP growth should result in higher stock market returns. Jay Ritter and others have studied the effects of GDP growth on stock market returns from 1900-2002. They calculated a cross-sectional correlation of -0.37 between the compounded real return on equities and the compounded growth rate of real per capita GDP for the 16 countries studied. The implication is that high GDP growth actually coincides with negative stock market performance. At first glance, the result is perplexing.
Krugman and Young have shown that real economic growth in emerging markets comes from a combination of higher savings rates and more efficient use of labour. Furthermore, they found that as an economy grows, savings are primarily invested into new or existing firms through new debt and equity issuance. Capital investment into new firms is unlikely to impact shareholders of existing firms unless these existing firms profit from supplying some product or service to the upstarts. However, capital inflows to existing firms will have an impact on the existing shareholder base. Whether or not the existing shareholders benefit will depend on the extent to which earnings are reinvested into positive NPV projects (those that produce returns in excess of the firm’s cost of capital) and share dilution.
Existing shareholders could benefit from increased capital inflows. But again, this assumes that the firm is using this new capital to invest in positive NPV projects. These projects would enable the firm to produce higher earnings and cash flows in the future. Higher future cash flows should translate into higher dividends and boost returns.
However, capital reinvestment is typically a net negative for existing shareholders of emerging market firms. Government interference and influence, less developed legal frameworks, fewer regulations, and scarce domestic investment opportunities are but a few of the issues that increase the difficulty of the task of capital allocation amongst firms in emerging markets. In many cases, these firms’ managers may not even be incentivised to increase shareholder value at all but, rather, are incentivised by some other metric, like their ability to create new jobs.
Dilution is another key factor that limits the benefits of economic growth from accruing to existing shareholders. New equity issuance dilutes existing shareholders' ownership interest. Dilution has been shown to be a significant drag on returns in all markets, but especially in emerging markets. Rob Arnott and William Bernstein found that the “dilution drag” in emerging markets was 7% annualised from 1990 to 2003. In that same vein, Morningstar's Samuel Lee noted that a 7% dilution drag was evident in the MSCI Emerging Markets Index from 2007 to 2011. Thus the combination of poor capital allocation and dilution drag often erases much of the benefit that fresh capital injections--properly invested--could generate for existing shareholders.
Negative Correlation Explained
Thus far, the factors we've discussed suggest that there is no relationship between GDP growth and stock market returns, implying that the correlation between the two should be near zero. But academics observe mostly negative correlations. What causes the correlation to skew negative?
Ritter, Siegel (1998), and other academics tend to agree that high growth expectations are compounded into stock prices and tend to cause P/E and price-to-dividend ratios to rise. When these multiples rise, more capital must be expended to receive the same level of dividends, which has the effect of lowering dividend yields. When current dividend yields shrink, expected future returns will decrease by the same percentage (holding cash flow growth constant). It turns out that lower current dividend yields not only result in lower expected returns but also lower realised returns, as shown by Siegel. Essentially, investor optimism about future growth (measured by increasing P/E and other multiples) results in a lower projection for future expected returns and lower realised returns on that investment. Therefore, when investors are overly optimistic regarding lofty GDP growth expectations, we can reasonably expect a negative correlation between GDP growth and stock market returns to exist.
Putting Theory to the Test
To better illustrate these conclusions, we looked at GDP growth and total stock market returns (as measured by the relevant MSCI Index) for 14 emerging and frontier countries from 1988 to 2010. The average correlation for these economies' GDP growth and total stock market returns over this time period was 0.06, which is slightly higher than was observed in the data set from 1900-2002. The higher correlation does not indicate a change in the fundamentals. Rather, the calculation is simply capturing business cycle effects inherent when shorter time periods are measured. Ideally, a longer term cross-sectional data series should be used to smooth out GDP growth figures.
While we’ve seen that concurrent GDP growth tends to be either negatively correlated with stock market returns over the long term, unexpected changes in GDP growth rates can have more pronounced effects on short-term stock market performance. Ritter observes that the probability of recessions and recoveries should impact the performance of the stock market. Therefore, if GDP dropped in one year compared to the previous year, the probability of recession would be said to have increased and stock markets would take a hit. To the best of our knowledge, this has not been tested rigorously but does have some logic behind it. Recessions and recoveries definitely impact the level of corporate earnings, implying some relationship should exist between an unexpected change in the trajectory of GDP and stock market returns. If a relationship does exist, then year-over-year changes in GDP growth rates should be more closely correlated to stock market returns than coincident GDP growth.
Using the 14 emerging and frontier market indices in our sample, we found that year-over-year changes in GDP growth rates are positively correlated to total stock market returns from 1988-2010. The average correlation of stock market returns to changes in GDP was 0.26, which is 4.3 times larger than the correlation between stock market returns and coincident GDP growth rates (0.06). It would seem, therefore, that some positive directional relationship--albeit somewhat weak based on this data--exists between year-over-year changes in GDP growth and stock market returns.
Expectations, Valuations Matter
Besides examining correlation data, it seems prudent to test whether or not stock markets in faster growing countries have actually outperformed those in more slowly growing countries over the long term. To test this hypothesis, we have constructed a hypothetical portfolio that selects and equally weights the MSCI benchmark indices for the three countries with the highest GDP growth rate in each year, and rebalanced and is reconstituted annually from 1988 to 2010. Selecting from our 14 country sample from over this period, this hypothetical portfolio returned 13.63% annualised with an annualised standard deviation of 41.85%.
We then constructed a second hypothetical portfolio by selecting, equally weighting, and annually re-constituting and re-balancing the three economies with the lowest GDP growth rates. This strategy returned 25.65% annualised with an annualised standard deviation of 51.18% over the period in question.
To contextualise these returns, the MSCI Emerging Markets index returned 11% annualised from 1988 to 2010. These results further substantiate the argument that GDP growth rates have minimal effects on stock market returns. As our analysis suggested, countries with the highest growth expectations are frequently overbought and their growth prospects overestimated such that they tend to produce lower returns for existing shareholders.
The empirical evidence suggests that investors are in fact overpaying for growth. But how much and to what extent are they overpaying? In an attempt to capture the premium paid for access to the fastest growing economies, we’ve constructed a third hypothetical portfolio that shorts the three fastest growing economies and goes long on the three slowest growing economies each year. Using the same 14 country sample, this strategy yielded a return of 8.55% annualised with an annualised standard deviation of 40.75% for the period from 1988 to 2010. While this method is not necessarily a rigorous test, it reinforces the fact that the stock markets of economies with experiencing lofty growth do not empirically provide better returns than those in countries experiencing slower growth.
So how should investors look to gain from investing in relatively fast-growing emerging and frontier markets? The central tenets of value investing apply to emerging and frontier markets every bit as much as they do in developed ones. When valuations are low and blood is in the streets, it is likely a good time to buy. In estimating future expected returns, cash flow growth and current dividend yields tend be less volatile value indicators than valuation multiples (P/E, P/B, etc.). Steady and growing dividends are an excellent signal of managerial competence and good corporate stewardship--especially in emerging markets. Unfortunately, an in-depth discussion of this topic is beyond the scope of this article. For a more granular analysis, please see my colleague Samuel Lee's article Indexer? Valuation Still Matters.
How to Invest
So let's extend this analysis into the present to make some inferences with regards to the 2011 and 2012 GDP growth prospects for the countries in our sample. In the table below are the three countries with the lowest and the highest expected GDP growth rates for 2011 and 2012 taken from our 14 country sample.
Based on the above data, South Africa meets both the criteria that the body of work examined above considers beneficial for future stock market returns--lower relative GDP growth and positive expected year over year change. Conversely, India and China strike out in both categories with high relative GDP growth and negative expected year over year change. Remember that high GDP growth in and of itself does not correlate with market returns, but that overly optimistic investors tend to overpay for high growth expectations causing returns to suffer. From this list, only Egypt does not have a specific ETF tracking it at this point. That said, here are a few country-specific ETFs that may be worth considering:
Lyxor ETF South Africa: Lyxor ETF South Africa is the largest and most liquid ETF tracking South African equities. The fund tracks the performance of the 40 largest stocks listed on the Johannesburg Stock Exchange (JSE) and its reference index is free-float market-capitalisation weighted. Lyxor uses synthetic replication to track the reference index. Given that BHP Billiton and Anglo American are amongst the index’s top constituents, it shouldn't be a surprise that mining is the largest sector represented comprising some 44.11% of the index’s value, followed by banks (10.24%) and mobile telecommunications (8.19%). Since March 2009, the South African mining sector has posted 21% annualised returns as measured by the FTSE South Africa Mining index. The outperformance is largely due to the meteoric rise of commodity prices and seemingly insatiable Chinese metal demand. Developing nations continue to put upward pressure on prices for staple commodities like iron ore, coal, and copper. Furthermore, a lack of new world-class deposit discoveries and diminishing ore grades mean that top-tier miners will likely be hard pressed to keep pace with rising demand, especially from emerging market economies, and should continue to reap the benefits of rising commodity prices going forward.
iShares MSCI Brazil: The iShares MSCI Brazil Index ETF is the largest and most liquid ETF tracking Brazilian equities. iShares uses physical replication to track its reference index, which aims to capture 85% of the Brazil’s total free float adjusted market capitalisation. The largest sector represented within the index is financials at 24.5% of its total value, followed by materials (23.5%) and energy (21.8%). Similar to the Lyxor ETF South Africa, the iShares MSCI Brazil has a historically exhibited a degree of correlation to commodity prices due to its top-heavy portfolio of energy and materials companies, which have benefited from Chinese demand.
