Does higher economic growth lead to higher returns?
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Does higher economic growth lead to higher returns?

Photo: Shutterstock

Photo: Shutterstock

Most investors/analysts view the economic growth of a country/region as a good predictor of stock market returns, and this perceived correlation between growth and returns can have a big influence on their asset allocation decisions.

Empirical evidence, however, suggests that it is far from clear that stocks in the fastest growing economies perform better than stocks in the slowest-growing economies, and vice versa.

Globalisation and the consequent ability of multinationals to produce and sell outside their domestic markets is considered to be one of the main reasons.

Another factor is that often investors can get too excited by raw growth data and overpay for companies in expanding economies which would already reflect the majority of the upside potential.

In a study which was conducted using data from 43 developed and emerging markets over 21 years (from the start of 1997 to the end of 2017), it emerged that net buybacks (when a company buys back its own shares) explain 80% of returns over the last 21 years.

Additionally, the authors of the study report only a weak relationship between dividend per share (DPS) growth and economic growth. The fastest-growing economies have clearly not enjoyed the highest stock market returns, and slow-growing economies have not all suffered poor returns.

The authors argue that the weak correlation occurs principally because shareholders in listed companies do not capture the economic growth of the market as a whole since new companies, which are more dynamic and have higher growth rates, are constantly being created.

In essence, therefore, GDP per capita growth—widely believed to be important in stock market performance – explains only a small portion of the growth of the stock market.

This, however, does not deter from the fact that companies operating in economic environments which are growing should in general be looked upon favourably.

When breaking it down to the individual company level, the pertinent objective is to identify the specific market factors which are going to affect a company rather than general market conditions.

By way of example from the local market, when considering the future growth of Malta International Airport plc, it would be a rather feeble argument to attribute the growth rate of the stock to the growth in the GDP of Malta, as this would probably explain only a small portion of the growth in earnings.

The key take-away is that investors seeking higher returns should focus on stocks which have the potential for strong dividend distribution/net buybacks rather than stocks which operate in countries with strong economic growth.

The study reports that 11 markets worldwide have seen more buybacks than issuance, including the United States. The positive tax environment in the US may increase buyback activity, as companies repatriate cash from overseas and also benefit from stronger earnings growth and corporate tax cuts. These factors should be accretive to US stock market returns.

Disclaimer: This article was issued by Simon Psaila, Financial Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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