Economic Growth: Great for Everyone but Investors

While the strength of these relationships is sensitive to the start and end dates of the sample period, the general findings are fairly robust over long time horizons. It's clear that higher economic growth does not necessarily translate into superior stock market returns over the long run.

Reasonable Assumptions?

This result should not be surprising given the strong assumptions that would be required to make the jump from GDP growth to stock market returns. In order for this relationship to hold, corporate profits as a share of GDP and valuation ratios would need to remain stable over time. Second, current shareholders' ownership stake of total corporate profits would also need to remain constant. In other words, there should be no dilution from new share issuance, private and public companies would need to grow at the same rate, and there could be no new enterprises or initial public offerings. All existing publicly listed companies would also need to generate substantially all of their revenue and profits from the domestic economy.

The Link Between Economic Growth and Profitability

In a closed economy, it would be reasonable to expect that total corporate profits would grow at a similar rate as the economy in the long run. Although the share of corporate profits relative to GDP fluctuates over time, it tends to revert to the mean. Profits cannot persistently grow faster than the economy because they would crowd out all other economic activity and attract new competitors. Similarly, total corporate profits should not grow slower than the economy in the long run, as firms exit unprofitable businesses, allowing those remaining to preserve margins. Of course, it is inappropriate to assume that any country United States investors have access to is closed. The largest companies listed in most countries tend to be multinational firms that generate a large portion of revenue and income outside their host country. For instance, the constituents of the S&P 500 generate close to 40% of their profits outside the U.S. This international exposure means that profits can grow at a different rate than the domestic economy, even in the long run.

Even if aggregate corporate profits grow in sync with GDP, dilution can prevent shareholders from enjoying the benefits of growth. Creative destruction is essential to economic growth. In aggregate all companies that are publicly listed today will grow slower than the economy because new entrants drive much of that growth. Between the time these new companies are launched and publicly listed, their growth dilutes most investors' ownership interest in the economy. Flagrant dilution of corporate earnings through employee stock grants and seasoned offerings is also a very real risk, particularly in developing countries with a tradition of poor corporate governance. Additionally, earnings growth can only create value if it allows firms to generate returns that exceed their cost of capital. High reinvestment rates may enhance both corporate and domestic economic growth but destroy shareholders' wealth through inefficient capital allocation.

Is Growth Already Priced In?

Growth expectations influence stock market valuations. Valuations are rich when investors expect strong growth. However, as developing economies mature, their growth rates slow and valuations tend to decline. Consequently, even when countries realize their expected growth rates, their stock markets may not keep pace.

The impact of lofty growth expectations on valuations can create a treadmill effect, whereby fast-growing economies must realize high growth in order to generate a competitive rate of return. For example, in the mid-1980s the so-called Asian tigers had experienced two decades of rapid growth and investors had high expectations for future growth. In contrast, several countries in Latin America were facing severe inflation, a debt crisis, and low expectations for future growth. As a result, according to research published by Peter Blair Henry and Prakash Kannan in "Growth and Returns in Emerging Markets," in 1986 Latin American stock markets were trading at 3.5 times earnings, while the Asian markets were trading at 18.3 times earnings. Over the next two decades, Latin American stock markets posted more than twice the annualized returns as the Asian markets, despite experiencing lower GDP growth over that horizon. This was because Latin American countries implemented economic reforms that allowed them to exceed investors' low expectations. Conversely, the Asian markets performed in line with investors' high expectations, which were already priced in.

What's an Investor to Do?

In order to benefit from economic growth, investors must identify markets that have the potential to exceed expectations. Even if fast-growing emerging markets do not offer superior risk-adjusted stock market returns, they can provide significant diversification benefits. Over the past 20 years, the MSCI Emerging Markets Index and S&P 500 were only 0.73 correlated. Emerging-markets equities may also offer a long-term hedge against a weakening U.S. dollar. 

In Hong Kong and Singapore, there are a number of ETFs tracking the broad emerging markets, including the db x-trackers MSCI Emerging Markets Index UCITS ETF (03009 listed in Hong Kong; J0M listed in Singapore) and Lyxor ETF MSCI Emerging Markets (H1N listed in Singapore); while ETFs tracking the broad Asian emerging markets include the db x-trackers MSCI EM Asia Index UCITS ETF (03035 listed in Hong Kong; J0N listed in Singapore) and iShares MSCI Emerging Asia Index ETF (02802 listed in Hong Kong). There are also many ETFs tracking selective countries in the emerging markets available for investors to gain exposure.

Alex Bryan is an ETF analyst with Morningstar

Jackie Choy, CFA, is an ETF Strategist with Morningstar, contributed on the Asian ETF examples.