While it might seem natural to look to countries with growing economies when searching for strong stock returns, or expecting periods of global gross domestic product (GDP) growth to coincide with positive stock market returns, studies have cast doubt on the connection. A 2012 study of 19 countries with continuously operating stock markets since 1900 found a negative correlation (-0.39) between real per-capita GDP growth and real stock returns. South Africa, for example, had the lowest GDP growth (about 1%) but was near the top in stock returns (over 7% annually). Japan, on the other hand, had the highest GDP growth (nearly 3%), but its stock market finished in the bottom third (with returns of about 3.5%).
Assessing data from emerging-markets countries since 1988 produced a very similar result. There was a negative correlation (-0.41) between real per-capita GDP growth and real stock returns. China had the highest GDP growth rate of the group (nearly 10%), but its markets actually declined during the period. Mexico had the most successful stock market (nearly 15%) but was near the bottom, and barely positive, in GDP growth. While perhaps counterintuitive, investors in many cases would have been better off investing in countries with currently weak economies but improving prospects for the future.
As the above data suggest, economic growth and market returns have distinct determinants. The size and skills of the labour force, the availability and deployment of capital, and the productivity improvements that come from new technology all contribute to economic growth. Much of the sluggishness evident in global economies over the past few years can be attributed to how capital is deployed versus its availability. Households in the U.S. have deleveraged and corporations have improved their balance sheets by significantly reducing capital expenditures. Future stock market returns, on the other hand, are driven by the current valuation of equities, the return of capital to shareholders and return on equity.
As the banking crisis in Cyprus demonstrated, risks remain in the world and I am optimistic about the prospects for equities. Stocks remain attractively valued relative to history and alternative asset classes. Current high dividend yields offered by equities provide a positive option compared with bond yields. At the same time, there are other trends that can affect the equity markets.
Commodity prices, in general, and energy prices, in particular, are declining. The shale gas revolution in the U.S. brought about a large increase in supply that has decreased energy prices. This trend could reduce expenses on many corporate balance sheets.
At the same time, reduced levels of capital spending are unsustainable and companies will eventually need to reinvest. This should increase global aggregate demand and, for many companies, should create opportunities for growth in sales and margins.
In Japan, Prime Minister Shinzo Abe is pursuing a reform policy (dubbed “Abenomics”) aimed at reversing the country’s long economic stagnation. Abe is focusing on ending deflation, providing short-term stimulus, weakening the yen and initiating supply-side reforms.
Finally, emerging markets continue to grow and change, shifting from their reliance on exports, while the individual consumer grows in importance. Disposable incomes are increasing in the developing world and household consumption is near an inflection point from which consumption expands at a nonlinear rate.
All of these developments will continue to present careful investors with long-term opportunities in environments of both slow and robust GDP growth.
Kurt Umbarger is global equity portfolio specialist, T. Rowe Price