GDP Growth, Corporate Profits and Equity Market Returns

Manish Gunwani

Manish Gunwani

CIO-Equity Investments
Reliance Mutual Fund

There is a remarkable obsession among investors about GDP growth. This is because it is not unreasonable for an investor to associate rapid economic growth with strong stock market returns. Hypothetically, if country A’s GDP is growing at 10% annually and country B’s is growing at 5% annually, one would expect the public companies in economy A to experience higher earnings growth and subsequently higher returns on equity when compared to companies in economy B.

Conventional wisdom suggests that GDP growth translates into corporate profits, which in turn translates into EPS and EPS growth finally translates into stock market returns. This is simple and makes intuitive sense. But does it hold in reality?

Looking at long-run market returns, nominal GDP growth and EPS growth for 8 developed markets, some interesting observations came to the fore:

  1. Surprisingly, nominal GDP growth does not exhibit strong correlation with either EPS growth or market returns
  2. On the other hand, strong correlation is observed between EPS growth and market returns

So what gives rise to the first anomaly? Some of the likely reasons are:

Globalization

Openness of an economy is an important factor which determines the extent of relationship between economic growth and market returns. The domestic companies of an economy may grow into Multinationals (MNCs) with their operations spread in different parts of the world. As a result, they may derive a significant proportion of their profits from abroad which does not get reflected in the home country’s GDP. In 2001, when Warren Buffet famously quoted that Market Capitalization to GDP is the ‘single best indicator’ of stock market valuation, the percentage of total US corporate profits that were derived from direct investments abroad was 20%. Since then, thanks to rapid globalization, this ratio has now become nearly 50%.

Market structure vs. Economic structure

The structure of an economy may be quite different from its market structure. For instance, a country’s growth might be increasingly driven by foreign direct investment (FDI) or unlisted companies. Economies where numbers of publicly listed companies are higher, the market cap to GDP also tends to be higher. In recent years what has been observed in many developed markets (US in particular) is that the number of public listed companies is sharply declining. For instance, the U.S. now has half as many publicly listed companies trading on its exchanges as it did at the peak in 1996. Also, many new age companies which are gaining substantial market share are still private like UBER. Lastly, the weight of a sector in the index might be quite different from its weight in the economy. Expectation of future growth may lead to disproportionate weight of a sector in the index vs. its current contribution to economic growth.

Corporate Earnings vs. EPS

There is a significant distinction between growth in aggregate earnings of an economy and the growth in EPS to which current investors have a claim. These two growth rates do not necessarily match since there are factors that can dilute or increase EPS without any change in aggregate earnings. For instance: share buy-backs help to prop-up EPS without changing aggregate earnings. At the same time, they are not great for economic growth. This is because the company instead of using the cash for productive capital expenditure uses it to retire its own equity. Sweden in the last decade and US markets in the last 5 years are some examples where due to buybacks EPS growth has been faster than corporate earnings as reflected in the national accounts. In a similar vein, constant dilution by companies for expansion may generate economic growth but not much EPS. A classic example is China. China was the fastest growing emerging market in the two decades to 2011, growing at 9.5% a year. Yet during the same period, China delivered the second-worst annualized stock market returns of -5.5% thanks to constant dilution which hurt shareholders.

Corporate Profits as a % of GDP

Economic growth is split between the providers of labour and capital. Two economies may be growing at the same rate but the share of labour and capital maybe quite different. In other words, corporate profits as a % of GDP (share of capital) may be very different in the two economies resulting in very different market caps. For instance, corporate profits as a proportion of GDP will be higher in those markets where competitive intensity is moderate and companies have some pricing power. A decline in competitive intensity means that the industry leaders are able to consolidate their position further and capture a greater share of economic growth, resulting in higher profits and more market cap.

There are other factors too that may lead to higher market cap to GDP in general. These include higher trade and financial openness of the economy, solid regulations and low inflation volatility. To conclude, one may intuitively think of stock returns as a result of the underlying economic growth.

Source: Hindu Businessline