Long-term investors who incorporate macro factors and expectations into their decision-making will be interested to hear the results of a JPMorgan report released Thursday on whether economic growth leads to higher stock returns.
The existence of a relationship should seem obvious, since higher GDP growth should lead to higher earnings growth, which in turn should lead to higher stock returns.
But the JPMorgan study suggests that this only applies to developed markets, not emerging ones. In developed markets, analysts find that a 1% increase in economic growth is associated with a 3% increase in long-term equity returns on average.
They also pointed to the fact that the market value of stocks in emerging markets is on average only one-fifth of GDP, while in developed markets it is 1.2 times GDP, which explains the “decoupling” between growth and stocks in emerging markets.
In developed markets, the relationship explains about 25% of the variation in long-term stock returns; the positive relationship with economic growth comes from earnings growth, as well as price-to-earnings and foreign exchange rate gains.
But despite the correlation between economic growth and returns in advanced countries, “long-term growth forecasts have large forecast errors,” and so there is no relationship between expected growth and actual returns. Moreover, returns are also uncorrelated with recent past growth.
However, analysts do not believe this is a reason not to take growth expectations into account when investing.
“Long-term investors all need to make assumptions about the long-term future returns on the asset classes they invest in,” they said. “Our results suggest that these frameworks should take into account that higher growth in any country tends to go hand in hand with higher multiples and currencies.”
The investment bank had previously forecast growth of 1.8% in the US, 1.4% in the eurozone and 0.8% in Japan over the next decade. “Given the uncertainty, this is one factor suggesting that the outperformance of US equities could be sustained,” the bank said.
JPMorgan Chase also has a strategic underweight of emerging market stocks relative to developed market stocks, but says it would be wary of taking that position if long-term economic growth were actually a useful signal in emerging economies.
It is also interesting that while theory suggests that economic growth may indeed be a factor in price so that the “unexpected portion” of growth contributes to returns, JPMorgan Chase finds that there is little relationship between the two.
“Our main interpretation is that investors are either focusing primarily on short-term market drivers and/or are not placing much faith in long-term growth prospects,” they added.
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