Seeing through the mist of GDP figures

It might seem obvious that a country with strong GDP growth will offer the best stockmarket growth potential. But in fact, the opposite is true. Tim Bennett explains why.

Having successfully coined the term Bric' in 2001 as a marketing weapon to sell Brazilian, Russian, Indian and Chinese funds, Goldman Sachs is at it again. This time we're being urged to buy the Mist' nations short for Mexico, Indonesia, South Korea and Turkey.

These countries have been plucked from a wider group of 11 new' emerging markets, in part because they account for 73% of the gross domestic product (GDP) of the combined group. However, while some emerging markets might be attractive, rapid GDP growth alone is no guarantee of investment success, as GMO's Jeremy Grantham points out.

The GDP trap

Surely a country with strong GDP growth must offer the best stockmarket growth potential? It seems obvious: the expansion of companies, and the production and sale of more goods and services, is a vital contributor to GDP growth. Yet, as Grantham notes, "GDP growth and stockmarket returns do not have any particularly obvious relationship, either empirically or in theory".

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The idea that a rapidly growing economy has no bearing on stockmarket returns seems a little counter-intuitive, but various studies of the topic have proved the point. One of the most comprehensive was carried out by Professors Elroy Dimson, Paul Marsh and Mike Staunton of the London School of Economics. They looked at long-term equity returns between 1900 and 2000 for a range of both developed and emerging markets. They found that GDP growth largely gave no clue as to what stockmarket performance for that market would then turn out to be. Indeed, if anything, higher GDP seemed to go hand in hand with lower equity returns, and vice versa.

The catch-22 of rapid growth

So what's going on? GDP growth is a result of combining two things population growth and labour productivity growth, says Grantham. All things being equal, a growing, increasingly productive economy will experience higher levels of wealth than its peers.

But here's the catch-22 for a firm trying to capitalise on rising demand. In order to expand the business, its owners will need to invest (in people and/or plant and machinery). The faster you want to grow, the harder you need to invest. But where does the money for that investment come from?

There are two answers either the business cuts its dividends, or it increases its capital base (by issuing more shares, say). Both are bad news short term one reduces the direct return to shareholders and the other dilutes their stake in the business. So "in practice", notes Grantham, "companies in fast-growing economies generally exhibit both low dividend payout ratios and high rates of dilution of shareholders".

What does this mean for investors?

If you want the best potential stock-price growth, you have to find the most fragile economies. Take Europe. Clearly Greece is the most beaten-up market around. If that's a little too contrarian for you, then Italy might be a better bet GDP fell at an annualised rate of 2.9% in the second quarter. The iShares FTSE MIB exchange traded fund (LSE: IMIB) tracks around 40 of the biggest listed Italian stocks.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.