There is no correlation between a country’s gross domestic product (GDP) growth and the real returns of its stock market, according to Vanguard chief investment officer Gus Sauter.
The current enthusiasm among investors for emerging markets can be put down to two major factors, according to Sauter: a tendency to "look in the rear-view mirror", and a mistaken impression that GDP growth is linked to stock market returns.
"The problem we have with that is financial theory mentions nothing about economic growth. Equity returns are not related to economic growth," Sauter said.
As evidence, he pointed to Vanguard research that compared geometric real stock returns with real GDP per capita growth rates between 1988 and 2010. The correlation between the two was 0.0176 for developed markets, and 0.003 for emerging markets.
"When we invest we’re buying companies, not countries. Even if China is growing at an extraordinarily rapid rate, it doesn’t mean Chinese companies’ earnings will grow at an extraordinarily rapid rate," Sauter said.
If the earnings of those companies did rise quickly, competition from overseas would quickly drive those excess profits away, Sauter added.
"You won’t be compensated for higher economic growth in the [emerging market] region, but you will be compensated for higher risk. If there is a premium, it’s due to volatility, not economic growth," Sauter said.
The lack of correlation between stock returns and GDP growth was also evident in developed markets, Sauter said. He cited US and UK GDP growth per capita over the 20th century: 3.2 per cent and 1.8 per cent, respectively. Compounded out, the US grew 17-fold between 1900 and 2000, and the UK grew 7-fold – but the equity returns in both countries was 10.1 per cent per year.
"You weren’t rewarded for extra economic growth in the US. You were being compensated for the risk and volatility in both marketplaces," Sauter said.
