Equity markets have historically been viewed as leading economic indicators – a rising equity market reflects a positive growth forecast of the underlying constituents and hence of the economy these constituents operate in – and vice versa. If you were a shareholder of a well-established company, which is already operating at maximum efficiency and addressing its biggest market share possible, given all other things being equal, one of the primary reasons for the share price to rise is if the underlying economy is growing. This, in turn, will result in a larger industry, meaning that the same percentage of a now larger market is larger in absolute terms and hence profits will grow. There is another reason and that is risk appetite, but let us put that to one side for now.

It might be unsustainable for the stock market to grow faster than the general economy

If the equity markets are rising, then it would be more than justified to conclude that investors are expecting some degree of economic growth. If the markets rally as we have witnessed in the first 10 weeks of this year, then the market is expecting accelerated economic growth. May I just remind you that the US markets are now in virgin territory having reached all-time highs last week. The US market is higher than the levels reached in October 2007, yet the current macro-economic data seems to be very far from what it was then. So what is happening? Doesn’t GDP drive market returns anymore?

The market currently seems to be moving on expectations rather than on facts. The most recent market strength in the US is not a coincidence but a reflection of the market convinced that the Fed intends to fulfil its statutory mandate by buying bonds until employment has declined to a normal level.

In other words, the market has started to believe that the Fed’s promise of an employment target might be credible and not merely a nice gesture. The market believes this because under the Fed’s inflationary QE3, the monetary base and the money supply have started to grow at a rather moderate pace. One need only read Ben Bernanke’s own writings to know that the purpose of quantitative easing is to raise inflation expectations and bond yields. The Fed seems to be convincing the markets that it is sincerely committed to fulfilling its full employment mandate, even if it means exceeding its inflation target.

This inflationary QE is also having an impact on currencies. Since the beginning of the year, USD has lost one per cent against the euro as the supply of USD is increasing. Over the long term, continuous monetary expansion leads to the destruction of the underlying currency (in this case, the USD) relative to assets with intrinsic value.

Although this can provide a tailwind to many businesses with pricing power, it may also be a detriment for the consumer as a resulting loss in purchasing power. While structuring investment portfolios both sides need to be catered for: equity exposure will expose you to the benefits of an improving economy while assets like gold may act as a safeguard against a weaker US dollar.

With respect to the correlation between GDP and stock markets, Pimco’s Bill Gross says that low GDP means a tough environment for equity. He makes the point that it might be unsustainable for the stock market to grow faster than the general economy, i.e. the GDP. Can we expect steady gains from the equity markets if we don’t have steady gains from the overall economy?

One fundamental difference between the two measures is that GDP is an actual reading whereas equity performance is a mix of both actual and expectation and it is precisely this expectation that creates the rubber band effect between the two.

As we are currently witnessing, this rubber band is being stretched – if the underlying economies start delivering, then the tension on the rubber band will start to ease. If GDP growth does not kick in, the rubber band will eventually snap (if stock markets keep rising).

At the moment we are not seeing a strong correlation between the fundamental economic performance and equity indices, but at some point stock markets will be bound by GDP growth or otherwise.

www.curmiandpartners.com

Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

Karl Micallef is an executive director at Curmi and Partners Ltd.