Economic Progress Doesn’t Equate to Market Returns

To start with a passive managed fund is the simpliest way approaching emerging market investments

Daniel Sotiroff 25.10.2017
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One of the pillars of virtually every investment thesis for emerging-markets stocks is these countries’ current or potential growth rates. The rationale typically follows the line that sustained high economic growth will fuel high rates of return for their respective stock markets. This reasoning is more fantasy than reality. Economic growth and stock market returns have generally moved in the same (positive) direction over long stretches of time. But there is little if any evidence to support a relationship between annual economic growth and stock market returns. History has shown that this is the case not only for emerging markets, but also for developed nations like the United States.

Gross domestic product is the broadest and simplest signal to use for measuring a country’s economic growth. It is the sum of four components: personal consumption, business investment, government spending, and exports minus imports. Based on these constituents, there would seem to be a reasonable argument that the returns generated by publicly traded companies could be related to economic growth. Consumers or government agencies purchase the goods and services produced by these firms (personal consumption and government spending). This activity generates profits that these companies can use to reinvest and grow their businesses (business investment). And firms can export their products for sale in foreign countries (exports minus imports). From January 1971 through December 2016, U.S. GDP grew at a nominal rate of 6.4% annually. The total return of the U.S. stock market, as measured by the Wilshire 5000 Index, was 10.6% per year during the same period. While different in magnitude, they were at least similar in direction.

A similar situation has occurred in developing nations overseas. China, for example, has experienced tremendous economic growth in the past several decades. From January 1995 through December 2016 its nominal GDP grew by 14.5% annually. But investors that used this strong economic growth to justify investment in Chinese stocks were no doubt disappointed. Despite exuberant economic progress, the annual total return of the MSCI China Investable Market Index was a scant 2.1% during the same period. Like the U.S. the magnitudes of these two metrics were very different but similar in direction. In 2005 Jay Ritter, a professor at the University of Florida, published a comprehensive paper on the subject of economic growth and stock market returns for 16 countries. His results confirm the relationships mentioned above, that economic growth and stock market returns move in the same direction across several decades or more but vary greatly in magnitude. Ritter’s data set goes back to 1900, demonstrating that these trends have been robust over the long run.

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Daniel Sotiroff  Daniel Sotiroff is an Analyst, Passive Strategies Research, for Morningstar.

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