Ok, so the title is deliberately provocative, but it is meant to highlight an important issue. As debates over the likely path of growth rates in China rumble on it is worth taking a bit of a step back and reminding ourselves as investors that the importance of GDP to equity returns is at best debatable.
On one side of the debate is the assertion that long term growth of the economy is irrelevant or even negatively correlated with equity market returns. This argument normally stems from evidence that shows that equity markets of countries with higher long term growth rates have actually tended to underperform those with lower rates. Based on this, investors in the Chinese market should be rubbing their hands with glee at the prospect of lower Chinese growth from here.
Sound counterintuitive? Well it should. This argument ignores differences across countries: rule of law, shareholder rights, dividend culture, and all those other areas which many (rightly or wrongly) believe are far more likely to be weak in high growth economies. By looking at a long term history it also ignores the large structural shifts that can happen in growth and return dynamics (wars, financial liberalisation, technological progress etc.). Most importantly, it ignores the fact that GDP growth is not always a proxy for the earnings growth of the stock market.
But what about within countries? Surely if economic growth picks up in the US, its stock market will outperform? There is more evidence for this. There is, as you may expect little evidence of correlation between current growth and equity returns, but if you can forecast GDP in the future you have a slightly better chance. Even better than that, if you can forecast changes in the market’s own expectations for growth you put the odds far more firmly in your favour.
So all we need to do is predict how the collected wisdom of the markets will change its own view about a variable, possibly mis-measured, that even central banks have been unsuccessful in predicting…easy!
The chart below shows one measure of how successful experts have been at forecasting GDP in China. It is based on a survey of (in this case) 23 of the world’s largest financial institutions and shows the average forecast for a single year’s GDP (labelled) at various points in time. So for example, at the start of 2011 the average prediction for GDP in 2012 (the light green line) was close to 9%. Over time you can see these expectations shifting; actual GDP in 2012 was closer to 7.5% (as shown by the end of the line).
Forecasters are usually surprised. This does not mean that one should ignore GDP, or the forecasts of others. In the M&G Episode team we do believe that there are useful patterns in these consensus expectations. People frequently display herding in their beliefs and tend to be unwilling to make radical predictions. As a result the consensus can be surprised for several years in a row before meaningfully changing their beliefs about the future.
However, more important for asset returns is the value that investors attach to their beliefs. We don’t know what GDP is going to be, but if we can observe that everyone else is extremely negative, then the possibility of, and price response to, a positive surprise could well be greater.
As always the starting point of valuation of the asset is key. A cheap asset can rally even in the face of bad news if it was too cheap in the first place! So China could slow, or slow less than expected, and the equity market still perform well. It is a question of understanding what is baked into the price and where you think you disagree with the market.
The interplay between growth surprises and valuation was best summed up by Jim O’Neill and his team at Goldman Sachs in May 2011:
‘Where valuations are attractive and growth surprises are likely to occur, equity prices should reward. Where valuations are not so attractive growth may be less important.’
Whether you place more emphasis on your ability to predict growth surprises, as has been suggested by Larry Summers recently, or upon observations of overly pessimistic valuations should vary from country to country and from period to period. The relationship between underlying earnings and GDP is not stable over time or across borders. For example, should you place less weight on domestic GDP given increasing globalisation? This is becoming an increasingly relevant question for China as it continues to take steps to open up foreign capital flows. Similarly can you believe in Chinese GDP numbers at all? The market today is sceptical, at best…
All these issues and more show that as always there is no ‘holy grail;’ no simple mechanistic approach with which to look markets. In the case of China we cannot simply observe weaker data and take a negative view, we must think more deeply about the evolution of the market’s own beliefs, the possibility for surprise, and the compensation we are being offered for risk. With valuations and sentiment where they are today it could well be that we do not need to see a strong improvement in GDP growth to generate returns as equity investors.