Spring 2017 – Is Economic Growth a Reliable Indicator of Future Equity Returns?

We recently learned that the US economy has grown at a 2.1% annual rate since the recovery began in 2009. This pace of expansion has been the weakest of any in modern times:

It seems to make sense to treat economic growth as an indicator of future equity returns. However, the relationship between economic growth and returns in the historical data has been shown to be weak.

 

 

This should not come as a surprise given that returns are determined by discount rates and investors’ aggregate expectations of future growth and cash flows.  Surprises relative to those expectations, whether positive or negative, may cause realized returns to differ from expectations. A relevant question for investors is whether their view of global growth should impact how they invest.  The answer may be illuminated by evaluating the following data:

The chart above shows that historically, differences in GDP growth over the past year contained little information about differences in equity returns this year.  In both developed and emerging markets, average annual returns were similar for high and low growth countries.  In fact, low growth countries had slightly higher average returns than high growth countries, although the return difference was not reliably different from zero.  In other words, there is no evidence that the return difference occurred by anything other than random chance.

The analysis is also extended to assume perfect foresight about GDP growth over the next year. This is not an implementable strategy because investors do not have the advantage of knowing economic growth in advance.  Yet even with perfect foresight of future GDP growth, investors would not have realized an advantage.  Once again,  low growth countries actually had higher returns than high growth countries; and once again, the difference is not great enough to have confidence that it is the result of anything other than random chance.

Differences in equity returns seem to be driven more by differences in discount rates than by differences in GDP growth, even under a perfect forecasting scenario.

The moral of the story is this:  knowledge about the health of the economy, whether positive or negative, should not be relied upon as an indicator of the future direction of the market. Future market returns will continue to be a result of future surprises, which are by definition unknowable now.

 

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