The studies on the relation between per capita GDP growth and returns on shares persistently find that the two are negatively correlated - i.e. a higher rate of growth of per capita GDP is associated with a lower return on shares. Cardiff Garcia and Neil Hume, in the Financial Times, recently logically used this data to deal with the relatively narrow issue of questioning analyses that the high growth rates of emerging markets, for example China, will lead to them displaying superior share performance to developed markets. But the implications of the overall finding are much more widespread and fundamental for economic policy. Specifically the implications of a negative correlation of per capita GDP growth and returns on shares include:
- The population's living standard, i.e its consumption, is on average positively determined by, and positively correlated with, growth of per capita GDP. However the return on shares is negatively correlated with per capita GDP growth. It follows that the interests of the population's living standards and the interests of shareholders are counterposed - the population has an interest in higher per capita GDP growth whereas shareholders, in terms of return on shares, would benefit from lower per capita GDP growth.
- Governments targeting high rates of increase in per capita GDP, that is high increases in living standards, should expect lower returns on shares than those with low rates of increase of per capita GDP, that is living standards. Therefore, high rates of per capita GDP and living standards, and high rates of growth of share prices/total return on shares, are counterposed and not complimentary objectives.
- These issues are in addition to the points made in the Financial Times that over the long run the higher economic growth rates of emerging economies would produce lower growth of share prices and total return on shares - this clearly fits China which has the highest rate of growth of any major economy but an underperforming share market.
It should be stressed that such processes operate 'other things being equal' and over long periods of time. But they provide a long term determinant of economic developments which underlays, and therefore inflects, more short term trends.
Given the widespread implications of this issue the present article therefore outlines the data and examines in more detail some of the implications.
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Not just emerging but developed economies
The Beyond BRICs section of the Financial Times recently analysed a report by Deutsche Bank's John-Paul Smith which argued that share prices in emerging markets will suffer negative trends due to these countries government policies. The article however failed to provide the essential context that a negative correlation exists between per capita GDP growth and share price growth and total return on shares not only in emerging but in developed economies. It therefore follows, other things being equal, that high per capita GDP growth in some emerging markets would be anticipated to be correlated with underperformance of their shares.
However, this clearly raises a more general issue. Given that the aim of economic policy is to increase sustainable GDP per capita, as this makes possible increased living standards, this goal necessarily means that governments in both emerging and developed economies have to target high GDP per capita growth even although this will be necessarily be associated with lower share price growth and lower return on shares. The opposite course, targeting higher share prices and higher return on shares at the expense of lower GDP per capita growth, and therefore lower living standards, would mean placing the interests of the population lower than that of shareholders - a goal which, if being pursued, should be explicitly stated and would be unlikely to command widespread support.
More specifically John-Paul Smith criticised governments of emerging markets on the grounds that: ‘GEM (Global Emerging Markets) companies are increasingly seen as “facilitators” for the broader economy, on the Chinese model, across many GEM markets.’ Stefan Wagstyl of the Financial Times paraphrased Smith as arguing: ‘The state will drive the redistribution of resources away from shareholders and in favour of labour.’
However it is well established in the studies on the correlation between share price growth/total return on shares and per capita GDP growth - for example Siegel's Stocks for the Long Run, Dimson, Marsh and Staunton’s Triumph of the Optimists and Ritter’s Economic Growth and Equity Returns - that a negative correlation between per capita GDP growth and share prices exists in both developed and developing economies. Such negative correlation is not due specifically to government policies in emerging markets but is an overall feature of economic growth.1
Turning first to the data establishing the negative correlation between GDP per capita growth and share prices, Siegel found: 'Real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual [developed] countries is associated with lower returns to equity investors. Similarly, the stock returns for the developing countries against their GDP growth are plotted in Figure 81-b Again... there is a negative relation between the returns in individual countries and the growth rates of their GDP.' (Siegel p124) Siegel's findings for developed economies are shown in Figure 1 and those for developing economies in Figure 2.
Dimson, Marsh and Staunton found, regarding the total real return on equities and GDP per capita growth: ‘statistically, the correlation is -0.27 for 1900-2000 and -0.03 for 1951-2000.' (Dimson et al p156)
Regarding the correlation of GDP per capita growth and share price increases Ritter found: ‘My calculations for… 16 [developed] countries over the 1900-2002 period get a correlation of -0.37.’
In a recent survey Jain and Kranson's ‘The Myth of GDP and Stock Market Returns’ noted: ‘The data shows clearly that, over long periods and when adjusted for inflation, stock market returns and GDP per capital growth are negatively correlated.’
Goldman Sachs private wealth group, in a review, recently noted that the overall negative correlation between GDP per capita growth and share price growth extended to different groups of economies when ranked by growth rate: ‘Dimson et al have shown that if one invested in the slowest growing quintile of countries during this hundred-year- plus period, the equity returns would have outperformed the fastest growing quintile by 3% a year… Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5% a year.’
This relation found by Goldman Sachs is shown in Figure 3.
Goldman Sachs noted China as illustrating this general trend: ‘China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns… China’s economy has outgrown that of the US by about 8% a year since the end of 1992 (the inception date of the MSCI China equity market index). Its equity market, however, has lagged that of the US by about 8% a year. Over the last 15 years, earnings per share growth in China has been negative 0.9% while that of the S&P 500 companies has been 5.4% a year. Most recently, in 2010, China has outgrown the US by an estimated 7% but the MSCI China Index has returned just 4.8% (the local Shanghai Composite Index is actually down 12.8%). On the other hand, US equities have returned 15.1%. Since the peak of US and Chinese equities in October 2007, China has outgrown the US by an estimated 10% a year, but Chinese equities have lagged the US by 2.7% a year.’ This data is shown in Figure 4.
Goldman Sachs survey therefore concluded: ‘Whether it is 1 year, 3 years or 18 years, economic growth has not translated into better investment returns in China … The evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies.‘
In a recent update of their study, for the Credit Suisse Global Investment Returns Yearbook, Dimson, Marsh and Staunton concluded: ‘[Our] Figure 2 ranks the real equity return of the 19 Yearbook countries over the period 1900–2009, from lowest to highest…. [our] Figure 2 shows that the supposed association between long-run real growth in GDP per capita and real equity returns is simply not there (the correlation is –0.23).’ This is shown in Figure 5.
Dividends, share prices and growth
In their study Dimson, Marsh and Staunton however noted an extremely close correlation between share prices/return on shares and dividend payments: ‘there is a high correlation (0.87) between real equity returns and real dividend growth across the 19 countries.’
Such a close correlation between dividend payments and share prices is related to the negative correlation between share prices and economic growth: ‘the claim that real dividends grow at the same rate as real GDP is clearly incorrect. Real dividend growth has lagged behind real GDP per capita growth in all but one country, averaging just –0.1%, and the correlation between the two is -0.30.’ Higher economic growth is correlated with lower dividends and vice versa.
The clearly established negative correlation between economic growth and share price growth has a number of implications:
- It must be understood that correlation by itself does not establish causality - i.e. the negative correlation between share price growth and return on shares and GDP per capita growth does not establish whether rapid economic growth causes lower returns on shares, or higher returns on shares causes lower GDP growth, or some other factor(s) causes both. The negative correlation however does exclude that high share prices cause high GDP per capita growth, and therefore that economic policy should aim to have high share price growth in order to stimulate economic growth. The negative correlation shows that high returns on shares are either irrelevant (i.e. non-causal) for economic growth or if causal then higher returns on shares are negative for economic growth.
- Underperformance of shares in emerging economies with high growth rates would be expected to flow from the negative correlation between GDP per capital growth and share prices. Other things being equal, the more rapid the growth of GDP per capita the greater the underperformance of shares that would be anticipated - this clearly fits China.
- As the negative correlation of GDP per capita growth and share prices exists in both developed and developing economies pointing to underperformance of share prices in emerging markets does not justify the claim that underperformance of shares in such markets is due to government policy – except that such an underperformance would necessarily follow from the (desirable) policy of ensuring high GDP per capita growth.
- If share prices are negatively correlated with GDP per capita growth, but dividend payments are positively correlated with returns on shares, this again fits the case of China. China experiences high GDP per capita growth but low dividend payments due in substantial part to the large role played in the economy by State Owned Enterprises which pay extremely low, or zero, dividends to the state.
- Once again correlation does not establish causality, but the negative correlation of share price growth with per capita GDP growth, while dividend payments are positively correlated with share prices, means either that low dividend payments are beneficial for economic growth, that economic growth creates low dividend payments, or some other factor(s) causes both trends.
- Given the rate of growth of living standards is positively correlated with GDP per capita growth, whereas share prices are negatively correlated with GDP per capita growth, there is no reason to assume a positive correlation between rising living standards and rising share prices - i.e. that rising share prices will enhance living standards. Given that the aim is rising living standards there is therefore no reason for governments to target high share prices.
Taking the specific case of China, the negative correlation between share prices and GDP per capita growth is one reason this blog, which has a positive analysis of the growth of China’s economy, has a negative position as regards any major expectations for China’s share market.
Evidently the Financial Times and John-Paul Smith dealt primarily with short term trends in share prices which can can be affected by very different factors to the long term correlations outlined above. However:
- It is misleading to present underperformance of shares in emerging markets as being due to negative government policies when underperformance of shares in rapidly growing developing economies would be precisely expected to be correlated with their rapid growth.
- The implications of the negative correlation between GDP per capita growth and share prices, in both developed and developing economies, are far wider than those raised by John-Paul Smith and in the Financial Times article.
Notes & References