Another look at investment returns and economic growth
Investors and many fund managers tend to focus a lot on economic growth, past and future, but as we have mentioned before, there is a low to negative correlation between economic growth and investment returns.
The Credit Suisse Global Investment Returns yearbook 2010, opens under the heading, Emerging Markets, with this question, “The opening years of the twenty-first century have been a lost decade for equity investors, with the MSCI world index giving a return close to zero. However, emerging markets have been a bright spot, with an annualized return of 10%. Looking ahead, can we expect this differential to persist?"
This question was asked a year back. With the on-going focus on economic growth coming from emerging markets, it remains a valid question.
US fund managers, Brandes, reported on the work done by 3 London Business School professors and Credit Suisse that reveals that there is no evidence of a connection between growth in a country’s GDP and investment results. Credit Suisse looked at 83 countries, segmenting them based on their real GDP growth over the preceding five years. Then within each quintile an equal amount was invested into the equity market of each constituent country.
The process was repeated each year, and with some countries the study, GDP and return data went back to 1900.
The chart below reflects some of the countries and their corresponding GDP.
Returns, dividends and GDP growth, 1900 - 2009
Annualised equity returns by GDP growth
Very surprisingly the countries with the lowest GDP growth had the highest market returns.
In answering the question, as to what explains the disappointing returns from investing in high growth economies, Credit Suisse came up with these answers.
• It may have been a matter of luck, with low growth economies having resources, which with hindsight were undervalued, or
• Investors may have shunned equities in distressed countries, and bid up prices of assets in growing economies to unrealistic levels, or
• Stock prices reflect projected cash flows and their riskiness. When an economy grows, dividends tend to rise, risk is reduced and so the equity premium shrinks. With a smaller equity risk premium, subsequent equity returns should be expected to be lower.
In other words, they conclude, “If the market functions effectively, stock returns should decline after economic growth, and should increase after economic decline.” This is exactly what the research finds.
The research indicates that investors should not spend an inordinate amount on economic data such as GDP when making investment decision.
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