It is commonly suggested by the financial media and others that countries and regions of the world with high economic growth prospects are attractive places to invest. However, historical data does not confirm a positive relationship between faster economic growth and greater stock market returns.
Although their forecasts are often inaccurate, economists spend a great deal of time thinking about and forecasting future economic growth. Investors often consider these forecasts when deciding where to invest their money. The conventional view is that countries and regions with strong long-term economic growth prospects are more likely to deliver higher stock returns than those with slower growth expectations.
One popular theory is that corporate earnings in the aggregate should constitute roughly a constant percentage of GDP over the long run and, therefore, dividends will rise along with economic growth thus producing higher stock returns in faster growing economies.
Following this logic, asset allocation would be a straightforward process of favoring high growth regions and countries of the world at the expense of the slow growth areas. For example, economists generally agree that the long-run growth potential of Asia is higher than either the United States or Europe. Is getting higher returns on our portfolios as easy as overweighting Asian countries since the expected economic growth rate of the region is so much higher than both U.S. and Europe?
Of course, there is no free lunch in finance and market participants know which countries and regions of the world are expected to have higher economic growth in the future. These expectations are incorporated into current market prices, thereby making this knowledge of little value in making investment decisions.
Most important, several academic studies have failed to find a positive correlation between a country’s economic growth and its stock market’s return. British economists Dimson, Marsh, and Stanton find no evidence that economic growth is a predictor of future stock performance or that high growth economies outperform low growth ones. Similarly, Jay Ritter of the University of Florida says that future economic growth is largely irrelevant for predicting future equity returns.
Simply put, while short-run changes in GDP growth can affect stock prices, there is no necessary long-term connection. Economic growth is determined by growth in the supply of labor and increases in productivity. Stock returns, on the other hand, are determined by the cost of capital, which is the rate of return required by investors to bear the risk of owning stocks.
In other words, it is primarily risk that determines long-term stock returns, or the returns on any investment asset (not the growth rate of the economy). Some investment advisors recommend investing in fast-growing economies with the expectation of superior returns, but historically that strategy has not generally succeeded.
This is not to say there is no connection between economic growth and the stock market. The prosperity of companies and shareholders depends on the health of the economy at any point in time, but instead of GDP growth predicting stock returns, it is the stock market that predicts future GDP growth.
Just as global stock markets rose in 2017 in expectation of economic growth in 2018, economic researchers have found a statistically significant between a county’s economic growth and its prior-year’s stock market return. In short, a positive return on stocks in year t portends positive economic growth in year t+1.
The fact that the stock market discounts anticipated economic conditions and is a good predictor of future economic growth, suggests that free and competitive markets are efficient processors of information. This is good because the idea that free markets work is a central idea of capitalism and necessary for the proper functioning of capital markets.
In summary, buying into growth markets does not generate market-beating returns because markets anticipate the growth and factor this expectation into current prices. This underscores the importance of having a globally diversified portfolio with exposure to many different countries, regions and asset classes.