In 2023, the US economy grew 2.5%, beating both the average advanced economy and the consensus economic forecast. The Indian economy grew 7.7%, outpacing growth in China and the average emerging economy.
The US stock market rose 19.9%, outperforming global stocks. And the Indian market was up 13.6%, while the Chinese market fell 16.1%.
This sounds like common sense. A strong economy creates the environment for strong corporate revenue growth, strong earnings, and growing dividends.
But, when professors at London Business School studied the link between economic growth and stock market returns, they found a negative relationship. So, how do we square this and our common sense?
Persistent strong growth is rare
Long periods of strong growth – like in China before the COVID-19 crisis – are rare. Of the few historical examples since 1900, a number occurred in the build up to World War II or because of the reconstructions afterwards.
More usually, a three-year period of strong growth is followed by a few years of more moderate progress. Even the most successful economic stories have setbacks along the way.
We see a similar pattern when looking at economic forecasts.
The Citi US Economic Surprise index measures the extent which economic data releases exceed or fall short of economists' expectations.
A period of economic data coming in better than expectations is typically followed by a period of disappointing releases. Over the last 20 years, expectations for US economic activity were exceeded in 131 months and fell short in 110 months. Knowing this, the run of 15 months of positive surprises we’re having right now is unique.
Remember though, past performance isn’t a guide to the future. All investments rise and fall in value, meaning you could get back less than you invest.
What does this mean for stock investors?
Stock markets are forward looking, while economic data releases are the opposite. In fact, even economic data is released with a lag of weeks or months – so our readings of current conditions are still forecasts.
The historical performance of the economy is mostly priced into markets – just like the future expected performance. So, to gain a performance edge by selecting markets based on future growth means you have to bet against a well-informed consensus. We can’t find any evidence that investors can consistently time these cycles.
Stock investors don’t get the full benefits of an economic expansion. This growth typically needs new capital, diluting the gains for existing stockholders.
Also, some of the growth is driven by privately-owned businesses, governments, or entrepreneurs setting up new companies. Their returns might be ahead or behind those of stock market investors. Real dividend growth has historically lagged real growth in GDP per capita.
Value investing is a strategy where investors look to buy shares at a price which isn’t reflected as their true worth. In other words, they are 'cheap' or at a discount to what the true share price should be.
What does this mean for emerging markets?
We expect economic growth in these economies to exceed advanced economies. But that alone isn’t a reason to expect outperformance.
On average, investing in emerging economies means taking on more risk. Yet we think the risks in these countries haves fallen over the last generation as the strength of their institutions, such as central banks, has gone up. The same is true of – the global bodies that monitor their work.
But there’s still a gap. Higher risk means we expect a higher return in exchange for taking on more risk.
What’s more, these risks usually differ to those of advanced economies. This can offer diversification benefits for those able to accept the increased level of risk.
Where is the value?
‘Value’ investors can quote a lot of evidence that markets bid up the price of ‘growth’ stocks to the point where long-term returns are below their ‘cheaper’ peers. The long-term track record of simple value strategies supports this conclusion, despite value stocks lagging over the past decade.
The London Business School findings – where strong economies had relatively weak stock returns – might look like it’s implying the same is true at a country level. But the evidence is weak. And the negative relationship between economic growth and stock markets disappears when aggregate GDP is used in place of GDP per capita.
Growth investors look for high-quality companies that have the potential to deliver above-average growth, as measured by metrics like earnings, revenues, or cash flows.
The belief is that a company that can grow its earnings rapidly could see its share price rise faster than the average.
A good company doesn’t always make a good stock. The price you pay matters.
The same is true for good economies.
Investors should look at a wide range of economic and market fundamentals when selecting stock markets. Diversifying across different countries and regions can reduce expected risk without sacrificing expected returns.
This article isn’t personal advice. If you’re not sure if an investment’s right for you, ask for financial advice.
