Many investors are sticking with emerging markets despite their recent losses because they believe these offer superior long-term economic growth prospects. Such a strategy is dangerous because there is in fact little reason to suppose that good long-run economic growth will cause good equity returns.
In truth, this was first pointed out long ago. In 2005, Jay Ritter at the University of Florida showed that across 16 countries between 1900 and 2002 the correlation between economic growth and stock market returns was actually negative. And in 2010 economists at MSCI also found a negative correlation between growth and equity returns between 1958 and 2008.
One problem with the social sciences, however, is that findings must be continuously checked because what is true in some times and places isn’t necessarily true in other times and places. My chart provides such a check. It plots the annualised change in share prices for 45 countries in sterling terms (because this is what matters for UK investors) against real GDP growth. The 45 countries represent all of those in MSCI’s developed and emerging market indices.
If we include Greece, the correlation between growth and equity returns is positive, contrary to what Ritter and MSCI found. If we exclude Greece, however, the correlation is not statistically significant. Most countries have had pretty similar stock market returns in the last 10 years despite some big differences in real GDP growth.
Investors have been rewarded for avoiding economic basket cases, but they have not been so well recompensed for picking good economies: China and India have had the best GDP growth in our sample, but their equity returns haven’t been so remarkable.
In this sense, the main message of Ritter’s and MSCI’s research still holds: investors should not buy into a stock market if they believe a country offers superior economic growth. Even if that belief proves correct, the stock need not do unusually well.
One reason for this is that investors sometimes correctly anticipate economic growth and so price it into share prices beforehand, with the result that subsequent returns are only average. Markets are efficient sometimes. Back in 2008 investors foresaw that China and India would grow nicely, but didn’t anticipate the Greek crisis. That meant that China and India’s markets haven’t soared, but Greece’s has tanked.
What’s more, economic growth need not always benefit incumbent listed companies. It can instead raise wages or the profits of unlisted or overseas companies or those of companies that don’t yet exist. Economic growth is most likely to benefit incumbent companies if they have the political muscle or monopoly power to exclude potential competitors. But an economy with grievously rigged markets is unlikely to grow very much over the long run.
You might object here that the last 10 years are a misleading sample because it contains the global financial crisis and partial recovery therefrom.
Such an objection is mistaken.
For one thing, the fact that Ritter’s and MSCI’s main message (that GDP growth doesn’t necessarily translate into equity returns) still holds in such a different sample strengthens their conclusion. It looks like a pretty robust fact.
And for another, crises are an inevitable if irregular part of capitalism. You cannot invest as if they don’t happen. When they do, they contribute to the pattern in my chart, for equity returns to be quite similar. In a global crisis all stock markets fall and in the recovery they almost all rise. The rise and fall of global market risk reduces the payoffs to finding countries with good local economic growth.
None of this is to say we should avoid emerging markets – although the fact that momentum is against them and the Federal Reserve is raising interest rates are both reasons for near-term caution. There is a case for long-term investors to buy them. For one thing, they might be a way of spreading the risk of long-term economic stagnation in the UK. And for another, history tells us that investors have on average been rewarded for taking on the extra risks they carry: greater volatility and higher crash risk.
We should not, however, favour emerging markets merely because they offer better economic growth. Even if this is true – and history offers many examples of it not being so, many from South America alone – good economic growth does not necessarily mean decent stock market returns.
