This is an article written by Tom Ovnerud from Russell Investments on 9thNovember 2012. A good piece that we thought would be of interest on the differentiation between a countries economy and its market.
Can you guess which one of the 49 countries represented in the Russell Global Index has had the best stock market performance this year as of September 2012? The U.S.? Egypt? Norway? Perhaps Australia?
Would your guess change if I revealed that markets do not generally reflect the current economic or geopolitical situation – instead, they attempt to look forward and immediately incorporate the changes in expectations about future economic and corporate conditions?
I ask because, when I’m meeting with clients, I often get asked questions like “If you’re saying Europe is in a recession, then why are you still investing there?” or “Why aren’t you shifting money to the U.S. if it’s the strongest economy?”
The questions make sense: in theory, equity markets should be a reflection of the underlying strength of the economy. Some economic supply-side models attempt to model this relationship: they theorize that GDP growth translates to earnings-per-share (EPS) growth, which then translates into EPS/share growth and finally is reflected in stock price increases.
But, consider the case of companies that operate on a global scale – and hence derive a portion of their earnings from outside their country of domicile. In those cases, the more global a company is, the smaller is the percentage of its earnings that are related to the economy of the its country of domicile. The company’s home economy may not be growing at a fast clip, but the other countries the company is selling its products in may be thriving. This is especially true for developed markets, where a higher proportion of companies are global in nature.
But ultimately, the challenge with these questions is that they assume the market and the economy are one and the same thing. That logic would argue that if a country’s economy is languishing, then surely its market must be in the doldrums, too. In fact, as the charts below show, there has historically been a weak relationship (11% correlation) between annual stock returns for G7 countries1 and their respective concurrent GDP growth.
Source: IMF (GDP growth), MSCI (Country Index Returns)
In contrast, there has been a much stronger relationship (50% correlation) between those annual country returns and the following year’s GDP growth. That’s to say the G7 equity markets have anticipated changes in the economic cycle and incorporated new information immediately.
Source: IMF (GDP growth), MSCI (Country Index Returns)
This helps explain why, despite only tepid GDP growth, U.S. equity markets have had a double-digit run this year2: they are reflecting the mitigation of seriously negative scenarios in Europe and the anticipation of continued U.S. economic growth in 2013.
It may also explain why the prize for best-returning market year to date goes to… Egypt. Yes, you read that right. Despite its economy being in shambles on the heels of its revolution less than two years ago, its huge budget gap and poor employment situation, Egypt has had a 65% return between January 1 and September 30, 20123.
If, as investors, we could predict future economic outcomes with more certainty (how will Europe resolve its debt issue, will China avoid a “hard landing,” will the U.S. resolve its fiscal cliff), then we could benefit from that foresight by making commensurate investments. Unfortunately, that crystal ball is still hidden. Instead, we have found that constructing and maintaining a balanced, well-diversified portfolio is the most appropriate way to capture opportunities and control risk in an uncertain environment.
1The G7 or Group of Seven are arguably the world’s seven most powerful industrialized countries. They include the U.S., Japan, Germany, the UK, France, Italy and Canada.
2U.S. equity markets represented by Russell 3000 ® Index have returned 16% in 2012 as of September 30, 2012. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
3Russell Global Index as of September 30, 2012.
The Russell Global Index measures the performance of the global equity market based on all investable equity securities.
Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.
Morgan Stanley Capital International (MSCI) market capitalization weighted index composed of companies representative of the market structure of 47 Developed and Emerging Market countries in the Americas, Europe/Middle East, and Asia/Pacific Regions. RFS 9624-b