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Growth puzzle is like chasing ghosts

Deputy features editor, Fund Strategy

The relationship between economic growth and stockmarket performance has long been a contentious question.

For example, in presenting the investment case for China many people point to the strong economic growth in the region, yet others say this strength has never been reflected in stockmarkets.

Some argue that it would be ridiculous to imply that underlying economic growth has no bearing on the perceived value of companies.

Companies need to sell products and for that, they need willing buyers. People have more money in their pockets at times of economic expansion.

Yet a number of quantitative studies have found that over particular time periods that relationship is far from clear-cut, and can even have an inverse effect.

To an extent, the question misunderstands how asset valuations are reached. Asset prices can be assumed to incorporate economic growth expectations, therefore the connection between the two should be apparent. According to this analysis, stockmarkets are merely indicators of sentiment, with only a tangential relationship to economic activity in themselves.

An alternative viewpoint would be to view stock prices as a key factor in sentiment building and, through this, consumer spending. Rising stock prices provide an incentive for businesses and individuals to spend and increases economic activity.

The IMF’s World Economic Outlook released in May 2000 devoted a chapter to the topic entitled “Asset Prices and the Business Cycle”. One of the findings of the report was that between 1970 and 1999 “stock prices are found to have a significant predictive power on output growth in many countries”.

Perhaps unsurprisingly, this was found to be especially true of Anglo-Saxon economies such as Britain, the US, Ireland and Australia. Stock prices in Japan, Finland and Spain were also found to be leading indicators of real GDP growth.

While the evidence points to a link between the two, the report acknowledges that “causal relationships between price changes in either of these assets and output growth are complex and empirically difficult to identify”.

The study found that support for a wealth effect theory is strongest in countries where stock ownership is more prevalent among households. As a consequence, the impact was much more pronounced in the US than other countries surveyed – with consumer spending moving higher for every increase in stock market wealth.

Within this discussion there is still a great deal of disparity between countries and the divergence is even greater when Western countries are compared with developing countries.

A research paper released by Goldman Sachs Asset Management in May last year appeared to conclude the link was strongest between the expectation of growth and stockmarket performance.

The author suggests that a 100 basis point positive revision in GDP forecast for the following year would result, on average, in a 14% rise in advanced world equity prices and a 26% rise in growth markets.

Despite the increased sensitivity to growth revisions, the paper contends the wealth effect is likely to be less significant to growth markets

Despite the increased sensitivity to growth revisions, the paper contends the wealth effect is likely to be less significant to growth markets: “While the wealth channel has been found to be important in most advanced economies, it is unlikely that it is significant in Growth and Emerging countries, where the share of wealth held in equities is much smaller than in the developed world.”

Perhaps it is possible to extrapolate from the findings of both studies:
● There is undeniably a relationship between stockmarket performance and economic growth over the long term. That is not to say the stockmarket is a perfect indicator of economic activity, nor to suggest strong economic growth will necessarily be reflected in stock prices. The Goldman Sachs report concludes the key aspect is anticipation of sustainable economic growth, although this hasnot shielded stock prices in emerging economies from delivering some disappointing results over the past decade.

● The link between stock ownership by households and a positive contribution to economic growth from the wealth effect can create a virtuous circle. Where stock ownership by households is limited, the connection between markets and the economies of the countries in which they are based becomes far more opaque.

● If we are to assume both the above are correct, the current investment climate offers a challenge for advanced countries. With economies struggling to achieve meaningful growth and forecasts suggesting limited prospects for growth over the next few years, it would seem logical that stockmarkets have failed tmove upwards. Flat or falling stockmarkets will restrain consumption through a negative wealth effect, thereby reducing economic activity in these markets, turning the virtuouscircle into a vicious one.

Equity performance is only one area to look at in relation to the broader economic picture.

Moreover, increasing globalisation has reduced the reliance of companies on domestic revenue stream and caused their earnings to become, as Goldman Sachs points out, “less sensitive to domestic growth surprises and link more closely to the global growth story”.

The findings argue for greater participation in equity markets, particularly among domestic investors in fast growing economies.This would have the additional
effect of mitigating the impact of foreign capital outflows during market uncertainty.

Unfortunately we will not have the data to unravel to what degree stockmarkets are able to shrug off the current economic malaise in developed countries until after the fact.

However, one recent experience has taught us the performance of these markets often fall far short of what the efficient market hypothesis would have predicted.

Perhaps trying to find a perfect correlation between economic growth and stockmarket performance will become a similar exercise to chasing ghosts.

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