Searching for the Global Connection Between GDP Growth & Market Returns

We recently looked at the effects of GDP growth on the US stock market, but I want to dive a little deeper.

We didn’t see any real relationship between GDP growth and stock returns in the US, but what about around the world? Can GDP growth tell us anything about what global markets will do going forward?

Before digging into the data, let’s think about why new GDP growth numbers don’t move the markets. After all, it’s hard to argue that companies doing business in America don’t benefit from a higher GDP growth rate. A higher GDP means those companies as a whole are doing better.

That’s pretty much the idea for any business—the more stuff you sell, the better you are doing (at least in most cases).

But stock prices don’t track the release of these economic numbers. Financial markets move on expectations; they are not limited to the current official data set.

If you were looking to sell stock ABC and I was looking to buy it, we would both be trying to figure out what the company’s future looks like. Since you want to sell and I want to buy, we probably disagree on what ABC’s future holds, but this is the process the market uses to sort a company’s value.

Traders aren’t just looking at the companies themselves, they are looking at everything that will affect those companies, including GDP growth. They are constantly trying to figure out what the GDP numbers (and everything else) will look like in the future. When the actual numbers are released, market prices move based on how the actual numbers compare to everyone’s estimates.

Markets don’t move based on whether a new piece of info is good or bad in and of itself. They move based on how new information stacks up against expectations. So we shouldn’t be worried about the actual GDP growth rate (at least for our stock portfolio), but rather how those growth rates differ from what the market expected them to be.

There’s no reason to think this works differently globally (and a whole lot of reasons to believe that it works the same way), but the real test is to run the data and see what pops out.

Running the Data

Let’s start simple by plotting out annual GDP growth versus annual returns for both Developed (including the US) and Emerging Markets.
gdp growth and market returns

Sources: World Bank, MSCI, Morningstar. Shorter time periods shown for some countries due to data availability. Past performance is no guarantee of future results. See Data Appendix for details.

Looking at the charts, it’s hard to see much correlation—if you tell me what a country’s growth rate was, I can’t tell you anything meaningful about what its return was that year.

But this is a pretty gross approach. We’re tossing everything into a big pot and looking for a pattern. What if we look at GDP growth rates relative to that year’s overall growth?

We’ve categorized countries year by year as either high- or low-growth based on how last year’s GDP growth compared to that year’s median GDP growth rate (Developed and Emerging Markets have been separated). That way, we can see how stock returns did and if there is a meaningful difference between high- and low-growth countries.

Developed Markets (1975-2014) Emerging Markets (1995-2014)
Average Annual Returns Annual Standard Deviation Average Annual Returns Annual Standard Deviation
High Growth Countries 12.00% 19.01% 12.57% 38.88%
Low Growth Countries 13.14% 21.20% 12.91% 34.85%
Difference -1.14% -0.34%
t-statistic* -0.47 -0.08

Sources: World Bank, MSCI, International Finance Corporation (World Bank). Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or actual strategies and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. Please see Data Appendix for more information.

Not only was there no reliable statistical difference between high- and low-growth countries, low-growth countries actually did a little bit better than high-growth (though it’s hardly a reason to hope for low economic growth).

But let’s do the same analysis again, with one (pretty massive) tweak. Let’s say we know for certain how GDP growth rates will look for every country every year. Surely a correlation will pop up, right?

Developed Markets (1975-2014) Emerging Markets (1995-2014)
Average Annual Returns Annual Standard Deviation Average Annual Returns Annual Standard Deviation
High Growth Countries 11.23% 19.38% 13.47% 37.17%
Low Growth Countries 13.17% 21.63% 11.42% 36.20%
Difference -1.94% 2.04%
t-statistic* -0.74 0.67

Sources: World Bank, MSCI, International Finance Corporation (World Bank). Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or actual strategies and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. Please see Data Appendix for more information.

Well, no. Yes, the differences were bigger, and the chance that the difference is random noise is a little less likely (though the likelihood is still quite high), but it’s still a coin flip. Low-growth countries won again in the Developed Markets, but high-growth countries came out ahead in the Emerging Markets.

So even with the impossible advantage of perfect foresight into GDP growth rates, we can’t reliably profit from that information.

Markets Move On New Information

Looking at all of this data, it’s pretty clear that the level of GDP growth rates does nothing for us.

Let’s think through an example here. Say I think GDP growth rates will nosedive next year and the markets will follow suit, so I sell my equity holdings to avoid the losses.

Well, if I believe GDP growth rates are on the verge of dropping, other people probably have the same idea and are trying to skip out on the losses, too. A whole bunch of those other people probably sold out before me, so our collective predictions regarding GDP growth rates are now baked into the market prices. Future returns will be based on the difference between our predictions and reality.

If they are higher than we expected, then we drove prices down too far and the market will go up. If they’re lower, we didn’t drive prices down far enough and the markets will go down. But notice how the returns are driven by how the new piece of info relates to our estimates.

If you’re thinking that this makes it incredibly hard to beat the market, well, you’re right. Consistently beating the market is almost impossible (and the almost is only in there because I don’t like definitive statements). So where does that leave you?

It remains that you should focus on building an inexpensive, well diversified portfolio, designed around your risk tolerance so you can stay disciplined and harvest the markets returns you deserve for putting your money at risk.

For more on how the market’s work—and how to use that to your advantage—take a look at our ebook, “A Minimalist’s Guide to Understanding the Financial Markets.”

 

 


* A t-statistic is a measure for the reliability of an average return difference. Normally, a t-statistic of at least 2 in absolute value is necessary to reliably say that the result is different from zero.

Data Appendix

Developed markets since 1975 (unless stated differently):
MSCI Australia Index (net div.), MSCI Austria Index (net div.) (from 1980), MSCI Belgium Index (net div.), MSCI Canada Index (net div.), MSCI Denmark Index (net div.) (1980), MSCI Finland Index (net div.) (1988), MSCI France Index (net div.), MSCI Germany Index (net div.), MSCI Hong Kong Index (net div.), MSCI Ireland Index (net div.) (1988), MSCI Israel Index (net div.) (1999), MSCI Italy Index (net div.), MSCI Japan Index (net div.), MSCI Netherlands Index (net div.), MSCI New Zealand Index (net div.) (1988), MSCI Norway Index (net div.), MSCI Portugal Index (net div.) (1990), MSCI Singapore Index (net div.), MSCI Spain Index (net div.), MSCI Sweden Index (net div.), MSCI Switzerland Index (net div.) (1981), MSCI United Kingdom Index (net div.), and the MSCI USA Index (net div.).

All of the following emerging markets are included since 1995 for Exhibit 1.

For Exhibit 2, since 1995 (unless stated differently):
MSCI Brazil Index (gross div.), MSCI Chile Index (gross div.), MSCI China Index (gross div.) (from 1996), MSCI Colombia Index (gross div.), MSCI Egypt Index (gross div.) (1998), MSCI Greece Index (gross div.), MSCI Hungary Index (gross div.), MSCI India Index (gross div.), MSCI Indonesia Index (gross div.), MSCI Korea Index (gross div.), MSCI Malaysia Index (gross div.), MSCI Mexico Index (gross div.), MSCI Peru Index (gross div.), MSCI Philippines Index (gross div.), MSCI Poland Index (gross div.), MSCI Russia Index (gross div.) (1998), MSCI South Africa Index (gross div.) (1996), MSCI Thailand Index (gross div.), MSCI Turkey Index (gross div.).

A country is included in the analysis for Exhibit 1 in a given year if MSCI index return and GDP growth data are available and in the analysis for Exhibit 2 if MSCI index return, country weight, and GDP growth data are available. Returns are in USD. GDP growth is real GDP growth in local currency, converted to USD using constant 2005 USD as provided by the World Bank.

 

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