New York. Investors worried about the International Monetary Fund’s prediction of an extended era of lousy economic growth should probably relax and take a deep breath.
Or rather, they might want to pay better attention to the price they pay for growth rather than the absolute rate at which the economy is going to grow.
The IMF this week released a new report predicting an extended period of sub-par growth in developed and emerging markets, laying the blame on slowing population growth and a puzzling lack of investment.
In developed economies potential growth will average just 1.6 percent over the next five years, up from the 1.3 percent we have had since 2008, but a lot weaker than the 2.3 percent clip enjoyed from 2001 to 2007.
While on first glance this cannot be called good news, the implications for stock market investors is perhaps less dire than you would assume. In fact, though studies find different outcomes, there does not appear to be a positive correlation between economic growth and equity returns, with some studies showing quite the opposite.
And this is not just a monetary policy driven phenomenon, though it is true that loose policy has helped to lift returns in recent years despite ropey growth.
“The cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative,” Jay Ritter of the University of Florida wrote in a benchmark 2004 study.
“Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.”
To be clear, low economic growth is a problem. Not only does it imply low growth in living standards and any number of other ills, it may pose serious problems for investors.
If sustained, low growth will make it more difficult for debt encumbered countries to grow their way out of trouble, something which ultimately may imply some mix of sovereign debt woes, rising taxes and declining currencies. Those are not a great backdrop for equity investors.
But overall economic growth, in and of itself, does not appear to be a driver of equity market returns.
Economic growth not correlated with investment returns
Ritter argues that not only is past economic growth is irrelevant for equity investors, but that even knowledge of future rates of growth is of little use.
If an economy grows and savings are invested, the gains on those new savings, and the new issues that rise up to satisfy them, do not accrue to existing equity holders.
“What matters for stock returns is how much of an economy’s growth comes from reinvestment of earnings into positive net present value investments in existing publicly traded companies, versus how much of it comes from personal savings that are then invested in private companies or in new issues of equity from existing companies.”
This argument throws the focus not onto the future rate of growth for the overall economy, but the quality of the investments being made by a given corporation.
It also makes crucial the price an investor pays for that growth, which of course may or may not occur. It also, and here we go well beyond Ritter’s argument, must follow that an investor has far more control over what stocks she chooses to buy than the overall rate of growth in an economy.
Demographic crunch and low investment
Two elements of the IMF study are potentially troubling for equity investors.
The first is the fact that a demographic crunch is hurting potential growth. The working age population will, from 2020, be contracting in Germany and Japan, with Korea and China not far behind.
Demographics may prove tough for equities because investors have distinctly different behaviors during different parts of their lives, building up savings when young and consuming them when older. This implies lots of sellers in coming years and fewer buyers.
Secondly, growth is, in the IMF’s view, being impaired by a lack of investment in large economies that is difficult to explain.
Here, and again this is not the IMF’s argument, we may have a corporate governance issue.
Because of the way executive compensation works, especially in the US, there may be a perverse incentive for executives to stint on long-term investment in order to buy back shares and prop up the value of their share options. That is a tactic which can work, but only for so long.
Perhaps, given all the variables the best advice is for investors to concentrate on what they can control: what they are willing to pay.
James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. He can be emailed at firstname.lastname@example.org.