ACCURATE GDP FORECASTS PROVE VITAL TO EQUITIES PERFORMANCE / THE FINANCIAL TIMES MARKETS ( VERY HIGHLY RECOMMENDED READING )

Accurate GDP forecasts prove vital to equities performance

By Jim O’Neill

Published: June 6 2011 12:48


Financial market participants spend much of their time responding to economic statistics. Better than expected data releases are regarded as good, and poorer ones bad. It would seem obvious in principle. For equity markets in general, stronger growth would imply stronger company earnings and vice versa.

Yet there is a body of literature that pertains to refute this simple notion, by showing historically there is no correlation between stock markets and countries’ real gross domestic product growth. In fact, some countries which typically have slower growth have had much more rewarding stock markets.


We published a paper in which we sought to refute the notion that there is no relationship between real GDP growth and the performance of equity markets. We argue that stock markets correctly anticipate positive growth surprises and punish growth disappointments. The key is what are people’s expectations and what is the valuation of the market when judgment about future growth is being made.


There is a major difference in the relationship between real GDP growth and equity markets than their apparent correlation. Indeed, the fact that statistical analysis can be performed to show a lack of correlation between GDP growth and equity markets is rather misleading. Correlation is not causation. The task facing investors at any moment in time is the future. It is as simple and as complicated as that. Financial markets at any moment in time, especially in an era of easy access to information, should provide the best guide to the future. For economic forecasters, the challenge is having a better forecast than the market has today.


In our paper, we show that equity markets are greatly influenced by changes in GDP growth expectations. For successful investors, the key is to combine a better view of future growth with today’s valuations. Where markets are attractively valued and real GDP growth positively surprises, it is highly likely their markets will outperform.


Conversely, where markets are expensive and real GDP growth disappoints, they will underperform, perhaps significantly. The bigger the discrepancy between today’s valuation and what happens, the bigger the opportunity. This applies to so-called emerging markets as well, even if many emerging market countries have not persistently rewarded investors.


It might help if we stopped thinking about the history of emerging markets and began to think about them, or at least some of them, as “growth markets”. Over the past decade, we have evidence that the previous multi-decade experience, where some emerging markets have not delivered strong investor returns despite healthy GDP growth, might have been broken. Many emerging markets showed strong real GDP growth, contributed to rising global GDP, and with it, earnings in both public and private companies in both developed and emerging countries.


Yet many investors remain cautious, not least because the convention is still to regard so many of them as emerging markets. By doing so, this confirms the mental bias about these countries’ natural state and history. In the process, this generally ensures that current valuations do not become too excessive. But this could prove supportive for growth markets. It means that if some countries positively outstrip expectations, it is highly likely that their markets will give positive surprises in terms of returns and perhaps more genuine diversification from the US.


Within this overall framework, China deserves a special focus because it is so central to the future for the world economy, and directly and indirectly markets. Some cite China as a good example of a country that can deliver strong real GDP growth but that does not deliver strong returns through its public equity markets.


Many like to point out that, even during the past decade of strong emerging market performance, China has underperformed other big growth markets, despite the fact that its growth rate was stronger. The implication is that China can easily deliver a lot of growth but not much profit for those that try to invest in it.


It is true that, compared with the likes of Brazil and India, China’s stock market has not rewarded investors with the real growth the nation has experienced. Much of China’s growth in the past decade was driven by low value exports and state sponsored infrastructure investment. But China’s stock market is reasonably, perhaps even attractively, priced compared with much of the past decade. Somewhat slightly lower real GDP growth in China this decade, perhaps in the vicinity of 7-8 per cent, with a stronger share of consumption and a lower share of exports and investment, might be quite likely associated with a stronger equity market, and lay the ground for another leg higher in global equity markets but one that is not based on leadership of commodities.


Having a more accurate view of future growth than today’s consensus remains the key task we face, and it does not matter whether it is China, the US or Timbuktu.


Jim O’Neill is chairman of Goldman Sachs Asset Management. This piece was co-authored by Anna Stupnytska and James Wrisdale, economists at GSAM
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Copyright The Financial Times Limited 2011