Does higher growth boost long-term equity returns?

Long-term investors who incorporate macro factors and forecasts into their decision-making would be interested to learn the findings of J.P. Morgan’s report published Thursday on whether economic growth leads to higher equity returns.

Intuitively, that there should be a correlation seems obvious, given higher GDP growth should lead to higher earnings growth which should in turn result in higher equity returns.

However, J.P. Morgan’s study finds that this is true only of developed markets, not emerging markets. In developed markets, analysts find that a 1% increase in economic growth is associated with around 3% higher long-term equity returns on average.

They also pointed to the fact that equity market caps in emerging markets are on average only a fifth of their GDP, while in developed markets, they are 1.2x GDP, which would explain the “disconnect” between growth and equities in emerging markets.

In developed markets, the relationship explains about 25% of long-term equity return variation; and the positive relationship with economic growth comes from earnings growth, as well as P/E and FX gains.

Despite the correlation between economic growth and returns in developed countries however, “long-term growth forecasts come with large forecasting errors,” so that there is no relationship between forecast growth and actual returns. Moreover, returns are also not related to recent past growth.

However, analysts don’t think this is a reason to not consider growth forecasts when investing.

“Large long-term investors all need to make assumptions about future long-term returns on the asset classes they invest in. 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,” they said.

The investment bank had previously forecast decade-ahead growth of 1.8% for the U.S., 1.4% for the Euro area and 0.8% for Japan. “Bearing in mind the uncertainty, this is one factor suggesting outperformance of US equities can be sustained,” they said.

J.P. Morgan is also strategically underweight emerging market equities versus developed market equities, but says they would have been wary to take this stance if long-term economic growth were indeed a useful signal in emerging economies.

Also, interestingly, while theory would suggest economic growth would already be factored into the price so that the “unexpected part” of growth should contribute to returns, J.P. Morgan finds that there is a weak relationship between the two.

“Our main interpretation is that investors either focus primarily on short-term drivers of markets and/or do not put much credence in long-term growth projections,” they added.

Source: Investing.com