Who dances with whom in this tango?

Here are insights on the link between GDP growth, corporate profits and equity returns

There is a remarkable obsession among investors with GDP growth. This is because it is not unreasonable for an investor to associate rapid economic growth with strong stock market returns.

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 eight developed markets, some interesting observations came to the fore:

Surprisingly, nominal GDP growth does not exhibit strong correlation with either EPS growth or market returns.

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:


The 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) deriving a significant proportion of their profits from abroad, which does not get reflected in the home country’s GDP. In 2001, when Warren Buffett famously said that market capitalisation 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 per cent. Since then, thanks to rapid globalisation, this ratio has now become nearly 50 per cent.

Economy vs market 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. In 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 (the US, in particular) is that the number of public listed companies is sharply declining.

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.

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 buybacks 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 five 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 per cent a year. Yet, during the same period, China delivered the second-worst annualised stock market returns of -5.5 per cent, thanks to constant dilution which hurt shareholders.

Corporate profits as % 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 may be quite different.

In other words, corporate profits as a percentage 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 sum up, one may intuitively think of stock returns as a result of the underlying economic growth.

The writer is CIO-Equity Investments, Reliance Mutual Fund

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