Thursday, June 30, 2011

Betting on Growth

From Outside the Flags, June 30, 2011
by Jim Parker, Vice President, Dimensional Fund Advisors

The world is changing. Economic fortunes appear to be switching from east to west. China and India are transforming into powerhouses as the established economies of the US and Europe struggle. What do investors do about it? The spectacular growth of emerging Asia in recent years, particularly in comparison to the developed economies of the West, has reignited a recurring debate about the relationship between economic growth and stock market returns.

It sounds intuitively right to most people that the best investment returns should be found in those countries with the fastest rates of economic growth. After all, shouldn’t investors receive the highest rewards in the most dynamic environments?

The problem is there is very little evidence that this is the case. In fact, study after study has shown there is little relationship between the speed of a nation’s economy and the performance of its stock market.

The table below plots annual GDP growth in constant prices against annual stock returns, as measured by MSCI indices and adjusted for inflation, in 16 developed economies over nearly four decades. Countries are ranked from the strongest growing over this period to the weakest. GDP and returns are in $US.

As can be seen, while Australia had the best real economic growth rate over this period, it ranked 13th out of 16 in terms of equity market returns. And while Sweden was fourth from the bottom of the table in economic growth terms, its market return was the strongest of the group. Likewise, Denmark – which was the second slowest growing economy over this period – had the second highest stock market returns.



These findings reflect those of my colleague Marlena Lee, who in a more detailed study published last year(1), found no statistical difference in the returns of high-growth countries versus low-growth countries. In fact, Marlena found that low-growth countries had higher average returns than high-growth countries. This applied both to developing and emerging markets.


This seeming contradiction can be explained by the nature of markets to discount new information very quickly when assessing future expected risks. So if there is news that the economy is growing strongly, investors may anticipate higher future profits and lower risks and bid up share prices to reflect that. This means that when prices are high due to lower discount rates, future expected returns are lower. Likewise, if the economy weakens and perceived risks rise, investors may bid down share prices in anticipation of lower profits or higher instability. So when discount rates push down prices, future expected returns are higher.

Another explanation for the economic growth-returns quandary is that individual equity markets, particularly in this age of globalisation, are not necessarily driven exclusively by the economies in which they are based. For instance, the US market represents more than 40 per cent of the MSCI World Investable Market Index. But does that mean a globally diversified market-cap weighted portfolio has a 40 per cent-plus exposure to the US economy? Not necessarily.

According to analysis by Standard & Poor’s (2), foreign sales reported as a percentage of sales of companies in the US S&P 500 index were 46.57 per cent in 2009. Among the fastest growing regions for US companies was Asia, where the proportion of foreign sales increased from 13.21 per cent in 2008 to 17.65 per cent in 2009. This stands to reason when you think of the global presence of US companies like Apple, Exxon Mobil, General Electric, Microsoft and Ford.

Similarly, in the UK market, firms like Pearson, Diageo, Vodafone and Rolls-Royce have a global presence. And in Australia, the market is dominated by large resource companies like BHP Billiton and Rio Tinto with substantial and growing exposures to the emerging economies of Asia.

In age of globalisation, where companies treat the world as their market and seek out buyers for their products and services from many different countries, it is simplistic to say that an exposure to a particular company in the country of its primary market listing equates to an exposure to that country’s economy.

Another theory is that the global investment landscape has fundamentally changed in the sense that we have entered a “new normal”. Features of this alleged new state include stubbornly sluggish economic growth, a general aversion to risk and a climate far less favourable to equity investment.

The problem with this theory is that history shows average returns from equity tend to be higher in bad times. While that might sound illogical, think about how the media and markets treat data surprises when the economy is in a trough.

For instance, the Australian economy recently recorded its worst quarter of economic growth since the recession of the early 1990s. The 1.2 per cent contraction in quarterly GDP was influenced by the run of natural disasters affecting Australia in the March quarter of 2011 and, on the surface, was shocking news.

The problem is the financial markets had been primed to expect a bad result. In other words, it was in the price. That meant when the numbers were released (and turned out slightly better than expectations), the Australian dollar actually bounced and the local equity market strengthened.

This is merely a way of reminding readers that markets are forward looking. We knew the news on the economy had been bad. But what matters for investors is what happens next. Without the powers of prophecy, we can’t ever know that. So we deal with it by diversifying according to our risk appetite and individual needs.

A final point is that a country’s economic footprint and its market footprint are different things. While China is a powerful global economic force, second only to the US in terms of GDP, its equity market – at least the part accessible by foreigners - is relatively small.

The MSCI All Country World Investable Market index, which covers 45 countries in developed and emerging markets, shows China’s weight at 2.34 per cent as of December 31, 2010, compared with 43.12 per cent for the US. By contrast, Australia, a middle-ranked economic power, has the sixth heaviest weighting in the MSCI at 3.45 per cent, equal to that of France(3).

So those who fret about an apparently declining US economy and the implications for their market-cap weighted global market portfolio should know that these changing economic forces are reflected in prices.

Country markets and national economies are different things. And the emergence of new economies and changing patterns of production and consumption will not just energise one country, but will change industries irrespective of borders.

For an investor that is a reminder of some familiar lessons – markets work, risk and return are related, diversification is essential and structure determines performance.

The author would like to thank Marlena Lee and Fiona Murphy for their assistance with this article

1. Lee, Marlena, ‘The Economics of Fiscal Deficits’, Dimensional, October, 2010

2. S&P-500 Global Sales, 2009

3. MSCI All Country World Investable Market Index, Factsheet, MSCI, Dec 2010