DANIEL GRIOLI challenges the widespread assumption that strong economic growth produces high equity returns.

Last month, I briefly described the epistemology that helps me to invest profitably. It is a focus on developing insights rather than acquiring facts. This article, while not strictly an asset allocation how-to, tackles a question that most asset allocators face: does economic growth result in stronger equity returns?

Several institutional investors have reduced their equity allocations to countries with low or negative economic growth in favour of faster growing economies, such as emerging market countries. At first glance this makes perfect sense. But there are a few problems with the idea that economic growth equals strong equity returns.

Recently, a friend asked me an interesting question: of all the countries that make up the MSCI World, which country’s equity market produced the best return in 2011? I’ll answer this question at the end of the article. First, I’ll try to explain why such a surprising result might be possible.


The theory


The basic idea behind the belief that economic growth equals strong equity returns is summarised in figure 1.

The theory says something like this: company revenues grow larger as economic activity increases and the increase in company revenues causes a corresponding increase in company earnings. It is this increase in earnings that contributes to higher share prices and strong equity returns.

Unfortunately, the supposed link between economic activity and equity returns is not so straightforward. There are factors that affect each link in this sequence. Some of the main ones are: the low corporate share of gross domestic product (GDP), earnings dilution and – you guessed it – valuation.


Low corporate share of GDP


If you had to guess, what would you say is the average share of GDP in corporate revenues in the United States? Would it be as high as 50 per cent? You might be more conservative and guess 20 per cent. According to Deutsche Bank, US corporate profits as a share of GDP since 1947 have only averaged 9.1 per cent. At their peak, they have never exceeded 15 per cent.

So what does this mean? It means that, in the US at least, the vast majority of the economic activity captured by the GDP statistic has little to do with companies listed on the country’s stock exchanges. Many companies earn a considerable part of their earnings overseas. Depending on circumstances, these earnings may not be fully captured in the GDP of the country where the company is listed. If this is the case, economic growth as measured by GDP might not necessarily translate into strong equity returns.

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