Hard To See the Connection Between Country Funds and GDP Growth Rates

Includes: CHN, IIF, IWV, RSX, TRF
by: Richard Shaw

Is comparing countries in terms of GDP growth helpful? It seems logical on the surface that a country’s GDP growth rate would have a lot to do with sales and profit growth and therefore stock market returns. It seems that financial journalists and economists think it is important, because they make such a big deal about it in stock market related news. But, where is the evidence that it matters? We're not sure.

In the short term, we are pretty sure it doesn’t matter. In the long-term, the idea of a linkage still appeals to logic, with the caveat that individual companies in each country may grow their sales and profits at much different rates than the national economy for any number of reasons.

We took a look at 2006 GDP growth rates for 30 countries with related country investment funds relative to their 1-yr, 3-yr and 10-yr trailing total returns. We didn’t see anything that suggested a linkage between GDP growth rates and stock market returns. The chart below shows the data.

[click image to enlarge]

Note that for Russia, India and China we used (NYSE:TRF), (NYSE:IIF) and (NYSE:CHN) respectively to fill in missing 3 and 10 year data points. For the Russell 3000, we estimated a synthetic ETF 10-year return by subtracting the IWV 20 basis point expense ratio from the Russell 3000 index 10-year return.

What we do see is a simple equal weight average 2006 GDP growth rate of 4.5% (compared to a world average of 5.3%) and a 12-month stock market simple equal weight average total return of 38.4% — no obvious logical relationship there. The 36-month return of 32.0% didn’t seem logically connected either. The 10-year 9.7% return was more in the same ball park.

Thinking we might have missed some important correlation, we also made a scatter diagram of the 2006 GDP growth rate versus the 3-year trailing total return. That was no help. The chart below shows no clear relationship.

With all the talk about China and India growing GDP faster than the rest of the world, we would have expected to see a more clear relationship between GDP growth rates and returns, but we didn’t see that. For example, Brazil is growing GDP at only 3.7% compared to 9.2% and 10.0% for India and China, yet Brazil exhibited substantially higher returns than India and a similar 12-month but higher than 36-month return than China.

The data tend to suggest that either GDP is essentially irrelevant to stock market returns, that the data show the rich getting richer and the poor getting poorer, or that markets are out of equilibrium with fundamental economics (unrealistic expectations).

Another possibility is that it is better to think of a country fund less as a fund about the country and more a fund about the leading companies in the country. In the case of the U.S., an argument could be made that the overall stock market does represent the country economy as a whole, but in smaller markets the concentration of assets in a small number of companies makes that concept a bit of a stretch.

For example, the U.S. broad market as represented by (NYSEARCA:IWV) (tracking the Russell 3000) has 2,970 stocks in the portfolio, the top 5 holdings account for only 10% of the fund, and are well diversified (Exxon (NYSE:XOM), GE (NYSE:GE), AT&T (NYSE:T), Citicorp (NYSE:C) and Microsoft (NASDAQ:MSFT)). On the other hand a fund such as (NYSEARCA:RSX) (Russia) has only 30 stocks, the top 5 stocks represent 40% of the portfolio, and are not well diversified (four of the top five are oil energy companies). See chart below for other examples:

The original question was whether GDP growth has much utility in making country allocations or country fund performance analysis. That answer appears to be NO.

We recognize that the purpose and character of business and corporations is to accumulate wealth by their operation, but we don’t understand how the differential between global GDP and global stock markets could be so great as a 7:1 world market returns to world GDP growth rate, unless the country funds are not a reflection of the countries themselves.

It’s easy to understand how money and wealth can shift from one corner of the world to the other, but it’s hard to understand how the value of all markets can grow so much faster than all economies.

We understand the scarcity and demand premium on energy and materials that emerging economies are creating, but we don’t understand how that translates into so many countries doing so well on a total stock market basis. We also understand that the largest and most successful companies in any country can outperform the country of their domicile, but comprehensive global outperformance doesn’t feel right to us.

In the same way that house prices cannot perpetually grow faster than wages, isn’t it reasonable to assume that world stock markets cannot perpetually grow faster than world economies?

We’re feeling a little cautious, but also don’t want to run and hide either. Our antennae are up, because the returns seem too good to be true, and that is often a bad sign.