Does Economic Growth Really Drive Equity Returns?
The following piece was actually penned prior to the recent US elections, but given the surprising result and volatile, yet positive market reaction, we thought it was worth pointing out how the article may help us understand the post-election market activity. In it we argue that what matters in regards to equity market returns isn’t the actual level of economic growth a country experiences, but the element of surprise in that growth (positive or negative) along with market valuations.
The dramatic post-election equity returns only serve to reinforce that premise. Markets rallied in the immediate aftermath of the election on the belief that president-elect Trump’s ambitious agenda would drive a change in our growth trajectory. Roughly 7 ½ years removed from the financial crisis investors had grown accepting of the idea that growth would at best be in the range of 2-3%. The Trump victory and pro-growth and reflation agenda brought with it the potential for that positive “element of surprise” that we could exceed 3%. Forget that it’ll be quite some time before we have any sense of success on that front, the mere potential was enough for investors to get excited about in the short term.
In the wealth management business, meetings with clients and prospective clients typically follow a fairly standard (and perhaps stale) pattern that in some order discusses recent market returns and expectations, account specifics and the economic environment. While it certainly varies, the materials and discussion centered on the economy more often than not take up a disproportionate amount of that discussion. As long-term, tax-averse, value-focused investors, at times we question the sanctity of that routine. There is plenty of evidence that shows economic growth, or lack thereof, does not actually correlate with equity market returns.
The intention of this article is not to state that economic growth does not matter; it unquestionably does. The purpose is to ask if investors and advisors are paying it too much attention and whether they are actually focused on the right metrics. To be fair, it’s an easy topic to decide to focus on when preparing presentation materials and having a discussion with a client. Informed or not, everyone seems to have an opinion on the economy and the endless list of economic statistics is easy fodder for a wealth advisor looking to have some colorful, fancy graphs to incorporate into a presentation.
To be clear: economic growth and more specifically the changes to economic growth absolutely do impact markets. What is less clear, however, is how they impact markets and how investors can use economic forecasts in reliably projecting returns and building portfolios. The sheer size, complexity, and interconnectedness of economies around the world obviously makes forecasting with any precision impossible. That doesn’t stop the army of Wall Street economists from building intricate econometric models and proudly reporting the results that they know will ultimately go through multiple future revisions. There is no shortage of humorous anecdotes about the lack of accuracy in economic prognostications, two of which I thought you may enjoy. The first:
Three economists went out hunting and came across a large deer. The first economist fired, but missed, by a meter to the left. The second economist fired but also missed, by a meter to the right. The third economist didn’t fire, but shouted in triumph, “We got it! We got it!”
The second is from David Rosenberg, Former Chief Economist & Strategist at Gluskin Sheff:
“Why did God invent economists? To make weathermen feel good about themselves.”
If economists can’t predict what the economy is actually going to do, then its use in predicting market returns seems rather illogical. For amusement let’s come back to that later and for now assume we had access to the one economist in the world who possessed an accurate crystal ball. He/she could indeed predict the GDP growth rates by country. I’d guess most of us, me included at one point in my career, would have confidently taken that information and invested in the highest growth countries, naturally assuming that the returns would also be correspondingly high. As logical as that sounds, the results of a study done by GMO, a well-respected global investment management firm, produced a very different end result.
In the chart below, produced by GMO in its Q4 2014 Quarterly Letter “Ditch the Good, Buy the Bad and the Ugly”, the orange triangles depict various developed market country growth rates on the X-axis and their equity market returns on the Y-axis. If higher actual growth drove higher equity market returns the orange triangles should generally follow a pattern that slopes up and to the right. Over this 30 year period (1980-2010) the opposite appears to be more of the norm with Sweden and Denmark having the highest actual returns with some of the slowest actual growth.
What causes this breakdown in what most would expect to be a rather straightforward, intuitive relationship? There could be quite a few factors driving the lack of any clear relationship: differences in motivation for market share growth versus profitability, share dilution as equity is raised to fuel outsized growth, or just the fact that GDP is measuring total country output and not just the output of the public sector. All of those certainly may play a role, but the most critical factor is likely just good, old fashioned valuation levels. At some price point, even a country experiencing negative growth or a deteriorating economy can be a good investment. Perhaps Sweden and Denmark were simply very cheap in 1980 and the modest growth that they did achieve was enough to return valuations to more normal levels.
This concept of valuation driving returns is illustrated in the below graph from the same GMO quarterly letter. In this illustration, country returns are being compared relative to the average country return over 3 year cycles. Focusing just on the two bars to the left, they compared the cheapest 20% of countries to the most expensive 20% of countries irrespective of growth levels. The differential was more than 5% in favor of simply buying the “cheap” countries. The middle set of bars adds to this comparison by including an additional variable, GDP “surprise”. This is meant to measure the difference between actual GDP growth and forecasted GDP growth when that differential was positive (i.e. faster growth than forecasters expected). The set of bars to the far right did the opposite in separating out when actual growth was less than projected. In both of these cases where countries were judged on “cheapness” and GDP “surprise”, the cheaper countries prevailed.
In summary, both valuation and growth matter. For growth, however, it’s not the actual level of growth that matters, but how much the actual differs from what is expected or the “surprise”. By definition this “surprise” means it really can’t be predicted or forecast, so as an input into an allocation model or return projection, it is extremely limited, if not outright useless.
One factor that is measurable, reliable, and predictive is valuation. Like most things in life this is simpler in theory than it is in practice. Buying cheap assets (and just as importantly selling expensive assets) typically means you are moving contrary to popular opinion. At the risk of being accused of overusing quotes in this article I’m reminded of another applicable quote, this time from the esteemed investor Warren Buffett when talking about investing in a contrarian manner:
“The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”
At Smith & Howard Wealth Management we remain focused on valuation, but are not contrarian for the sake of being contrarian. That just happens to typically be where the value is.
I would be happy to discuss our philosophy in more detail with you, or to explore with you how SHWM can work with you to achieve your financial goals. Please call me at 404-874-6244 or email me here.