The Missing Link

The Missing Link
The Economist, 19-May-2011

Economic growth helps investors only if they are clairvoyant

IT MAY seem obvious that faster economic growth should translate into higher equity returns. So it was quite an upset when academics found some years ago that this had not been the case in advanced countries over the 20th century. A subsequent paper discovered that the story was similar for developing economies as well.

These findings are awkward for emerging-market enthusiasts, who usually cite the superior growth prospects of such countries as the reason to invest in them. The counter-attack has duly been led by Jim O’Neill of Goldman Sachs Asset Management, who as a strategist coined the wildly successful BRIC acronym for the big developing economies of Brazil, Russia, India and China. Yet the surprise is not only that the response has been so long in coming but that the case it makes is so limited.

The Goldman paper admits that there is no evidence that equity returns for any given year are correlated with GDP growth in that same year. But it says that “equity markets are a lead indicator of GDP growth and react strongly to expectations about the future.”

This conclusion is hardly new. Stockmarket movements are a standard component of economic lead indicators. But this link is of little use to investors, who are looking instead for a lead indicator for equity performance.

Goldman argues that investors can take advantage of upgrades in economic-growth forecasts, which signal better prospective returns especially in the developing world. But its evidence for this claim is quite limited (just ten years of data for Brazil and Mexico, for example). If one takes the American market over the past 40 years then there is a negative relationship between changes in growth forecasts and equity returns.

This raises another doubt about the Goldman analysis. It is rather dismissive of the long-term stockmarket returns compiled by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS), who published their findings in 2005. “Averaging over a century fails to account for potentially important structural breaks and changes in the way economies and markets operate,” the report says somewhat sniffily. But the data are the data; it is not scientific to leave out large chunks of evidence.

But what if superior GDP growth showed up in stockmarket returns not immediately but over a prolonged period? The LBS academics tackle this issue in their 2010 work, the “Credit Suisse Global Investment Returns Yearbook”. They take the records of 83 countries from 1972 to 2009 (the most comprehensive set available) and rank them by GDP growth over the previous five years. Investing each year in the countries with the highest economic growth over the preceding five years earned an annual return of 18.4%, but investing in the lowest-growth countries returned 25.1%.

The interesting question is why this phenomenon should occur. One explanation is that investors pile into the stockmarkets of high-growth countries until they become overvalued. That herd-like behaviour makes their subsequent returns disappointing.

Another possibility is that economic growth does not always get captured by the stockmarket. The fastest-growing companies are often unquoted: in emerging markets, for example, many businesses are family-owned or controlled by the state. Even when businesses are quoted, their growth may be financed by additional equity issuance that does not boost the returns of existing shareholders. One paper suggested that this effect could reduce returns by as much as two percentage points a year.

Although analysts often forecast annual profits growth of 10% or more, the LBS academics found that dividends failed to keep pace with GDP growth in every developed country (bar one) they studied between 1900 and 2009. Re-invested dividends are a vital component of long-term equity returns.

If investors could forecast future economic growth, then Goldman would be right: superior returns would be achieved. But there is precious little sign that such clairvoyance exists. And the evidence that past economic growth is of no help remains pretty compelling.

Buttonwood: Action replay

There current credit crisis has been compared to many things in the financial press - 1987 crisis, LTCM etc - and the Economist seems to think that it is a more protracted like 2001, where initial Fed was received with euphoria but the subsequent ones were taken with trepedition given their implications about the economic growth trends. The Economist think that the final shoe to fall will be the dollar.

Buttonwood: Action replay
The Economist
Sep 27th 2007

Was the script for the recent turmoil written in 1998, 1990, or is it new?

LIKE generals condemned to fight the last war, investors seem fated to hark back to the last financial crisis. When markets plunged on “Black Monday” in October 1987, people feared a repeat of the Wall Street crash of 1929. Central banks cut interest rates in part because they wanted to avoid a re-run of the 1930s' depression.

But the world has suffered a lot of financial crises and it is not always clear which one to use as a benchmark. Take the central banks' responses to the recent problems in the credit markets. Do they suggest that we are looking at a repeat of 1998, when Long-Term Capital Management, a hedge fund, wobbled, or at 1990, when there was a financial crisis at savings-and-loans banks, then the main providers of American mortgages?

As David Bowers of Absolute Strategy Research points out, it makes an enormous difference which crisis (if either) is being replayed. In 1998 rate cuts quickly restored the animal spirits of investors and the dotcom bubble followed. If that pattern is to be repeated, investors should be piling into growth-sensitive sectors like emerging markets and commodities.

But in 1990 several rate cuts failed to stop the American economy from sliding into recession. That may be what happens once again now, especially as most observers believe it takes 12-18 months for changes in interest rates to have much economic effect. Figures released on September 25th showed that the inventory of unsold American homes is at its highest level since 1989. If we are following the 1990 script, then investors should be opting for the safety of Treasury bonds.

The strength of the world's stockmarkets since the Federal Reserve cut rates on September 18th indicates that most investors are, to misquote Prince, “partying like it's 1998”. The MSCI emerging-markets index reached a record high on September 24th, and the best-performing industries in share-price terms over the past month have been economically sensitive ones, such as mining and chemicals.

Ajay Kapur of the hedge fund First Horse Capital says that America's stockmarket normally returns 7.2% over the six months after the first rate cut in the cycle, even in periods when the economy is slipping into recession. When a downturn is avoided, the average six-monthly gain is 20.1%. Mr Kapur says the world is dominated by “fiat currency democracies” in which governments and central banks tend to give in to popular pressure and “print money” to avoid hard times. He believes the recent actions of the Fed, the European Central Bank and the Bank of England endorse his view.

Those bears who believe the drama is more likely to resemble 1990 than 1998 base their case on what they think are excessive levels of consumer debt. Clearly, many of them were far too early in predicting a debt-driven crisis; Peter Warburton's jeremiad “Debt and Delusion”, for example, was published back in 1999.

But they have a point now. As economies become more sophisticated, it may make sense for consumers to take on more debt as a means of smoothing their consumption over their lifetimes. Indeed, this should add to economic stability. Ironically, however, greater stability only encourages consumers to take on more debt since they are less fearful of losing their jobs in recessions.

Consumer debt cannot keep growing faster than income forever. That evil day has been delayed, over the past 20 years, by the downward trend in interest rates. But the bears think the crunch has now arrived, as it did in Japan in the 1990s.

The world may not have to wait too long to see whether they are right. As David Rosenberg, an economist at Merrill Lynch, recalls, the stockmarket rallied in response to a half-percentage-point rate cut in early January 2001. But by the time the Fed lowered rates again at the end of that month, its move was seen by investors as a sign of desperation.

Three months ago Buttonwood pointed to three portents that would suggest investors should prepare for the worst. One of those, higher credit spreads, has indeed appeared. Another was a resurgence of inflation. Although that looks unlikely in the short term, especially if economies weaken, the long-term chances of higher inflation must surely have gone up. Gold is at its highest level since it last peaked in 1980.

The final sign was a burst of yen strength (which would indicate an unwinding of speculative bets). The yen has risen against the dollar since June but there has been no sharp lurch higher; perhaps because the Japanese economy is itself weak. But if the gloomsters are to be proven right, we must surely see some turmoil in the currency markets first.