There's little relationship between country-level gross domestic product growth and local stock market returns. A better approach: identify companies that will benefit most and will pass on those benefits to investors
The conventional investment wisdom of “going where the growth is” would suggest increasing equity allocations to emerging markets. But our research shows that there's little relationship between country-level gross domestic product (GDP) growth and local stock market returns. The best way to take advantage of the developing world's growth is through bottom-up research that identifies companies that are most likely to benefit and that are priced attractively.
For decades, investors have been fascinated and attracted by the promise of emerging stock markets. Despite chronic volatility and, at times, breathtaking market plunges, the “rising tide” of economic growth in developing countries has been a compelling story. With economists predicting that growth in developing countries could outpace that of developed economies by as much as 200 percent to 300 percent over the next several decades, that story is more compelling than ever. (See “Future Emerging Markets,” p. 37.)
Not only are return expectations higher, but also many of the high-risk elements of emerging markets appear to be diminishing. In the past, emerging countries were rife with fiscal and monetary mismanagement, significantly contributing to their recurring growing pains. But over the last decade or so, a wave of structural reforms has swept across much of the developing world and emerging market fundamentals have strengthened dramatically. Current accounts have moved from deficits to surpluses (see “Emerging Market Growth,” p. 38); currencies are stronger; and formerly heavy debt burdens have been greatly reduced.
Do rising GDP estimates and more favorable risk factors signal the opportunity of a lifetime for investors? The common investment wisdom of “going where the growth is” would suggest increasing equity allocations to emerging markets — and that is exactly what investors have been doing. (See “Go Where the Growth Is,” p. 39.) From 2005 through 2009, U.S. investors poured more money into emerging markets equity funds than into U.S. funds, with about 40 percent of the flows going to single country or target group funds, such as the so-called BRIC countries: Brazil, Russia, India and China.1
But our research suggests caution. Simply allocating more of one's portfolio to growing markets (whether emerging or developed) fails to take into account an important but often overlooked truth: that typically there is no direct relationship between a country's GDP growth rate and investor returns. While the developing world will likely continue to expand its share of the global economy as well as of the world equity markets, this shift does not in and of itself guarantee outsized returns for investors in emerging markets stocks.
However, the maturation of the developing world does present a wealth of opportunity in two important respects: First, with the lowering of country-specific risks, investors are freer to pursue individual securities in emerging markets. Second, this maturation process creates opportunities for companies of all nationalities to participate in the growth. Identifying the best performers among those companies, regardless of their home base, is the key to benefiting from emerging markets growth. In other words, investors shouldn't simply “go where the growth is” — they should go where the profit growth is. And remember, the maturation of the emerging markets does not negate the need for vigilance toward risk. Avoiding over-concentration in a single country, industry or stock is still vitally important.
GDP Growth and Market Returns
Why doesn't GDP growth automatically translate into investor returns? It would seem to be intuitive: Stock values, after all, reflect corporate profit growth over time, which is a key factor of GDP growth. In the United States, for example, there is a clear long-term relationship between GDP growth and stock market returns since World War II. (See “The Story in the United States,” p. 39.) But there is also a lot of volatility in the relationship along the way. As “The Story in the United States” shows, stock market returns can “de-link” from GDP growth for long periods of time. In fact, over the most recent 20-year period, there is effectively no relationship between GDP growth and long-term investor returns on a local country basis in either the developed or emerging markets. (See “Outside the United States…,” p. 40, and “….and in Emerging Markets,” p. 40.)2
Why isn't the relationship between GDP growth and long-term investor returns more reliable? For insight, let's break down the sources of equity returns.
Where Equity Returns Come From
Total return — for all markets, not just emerging markets — comes from three components: the return from dividends, the return from changes in the price/earnings (P/E) multiple, and earnings-per-share (EPS) growth.
Only one component, EPS growth, is relevant when considering how economic growth may affect shareholder returns. That's because corporate earnings (the “E” in EPS) are directly related to economic growth, while dividend yield and changes to the P/E multiple have tenuous links at best. Let's look at each in turn:
Dividend yield, defined as cash payments to investors scaled by the price paid per share, is highly idiosyncratic, as it is determined by a company's directors. Clearly, investors are not pouring money into emerging markets because they think there will be a systemic change in dividend policy.
The P/E multiple is determined by the company's current stock price as much as it is by earnings. Changes in the P/E multiple are primarily an indicator of investors' perceptions about changes in the future earnings growth rate. If investors believe that the emerging markets will grow faster than current expectations, some P/E expansion might be expected.
EPS is the component most directly related to economic growth — at least to the extent that a rising GDP tide will “lift all boats” as local companies benefit from increasing economic activity. However, even this relationship is not as direct as one might expect, as we will see.
The Weak Link
The historical relationship between economic growth and EPS growth in the emerging markets — even after discounting the effects of significant outliers — is not particularly strong. (See “GDP and Earnings Per Share,” p. 41.) In fact, a striking outlier is China, arguably the most exciting GDP growth story of the past 15 years, where the EPS growth has been negative: -3 percent per annum.
Why isn't there a closer link between EPS and GDP? Because the connection is too tenuous. Think of it like a leaky water pipe: Even if GDP is gushing into the pipe, what emerges at the other end is a calm stream. (See “A Tenuous Connection,” p. 41, for an illustration of the sources of leakage.)
Who benefits from a nation's GDP growth? Broadly, the government (via taxes and state-owned enterprises, for example), labor (via personal consumption and investment), and corporations, as shown in the left bar of “A Tenuous Connection.” Stock market investors can't invest directly in government or labor, so some of the GDP growth gets diverted from EPS growth here. Corporations, in turn, fall into categories: private and public enterprises, as shown in the middle bar. Since the great majority of investors invest only in publicly traded companies, we can strip out the private enterprises. So, the share of earnings going to the stock market depends on — among other things — the extent of government's involvement in business and the bargaining power of labor, as well as the relative growth of public versus private business. The relative impact of all these factors varies greatly from country to country.
Last but not least, the right-hand bar shows a final “leak” from the pipeline: Public company earnings can be divided into the portion captured by new share issues and the portion tied to already existing shares. Only the existing shares, by definition, determine EPS growth. Further, new shares dilute the value of existing shares. The impact of equity issuance is especially pronounced in the emerging markets, where a large number of companies have migrated to the public markets since the late 1980s, and we can reasonably assume they will continue to do so as the markets grow. The expansion in the number of listed public companies has accounted for an increase of more than 21 percent in aggregate earnings of publicly traded companies per year over the past two decades, and an increase in total emerging markets capitalization of almost 25 percent annually. (See “New Share Issuance,” p. 42.)
The Chinese experience highlights yet another important, though often overlooked, disconnect in the GDP-to-EPS growth pipeline. Globalization encourages firms around the world to allocate portions of their investments and operations into foreign countries, often attracted by cheap labor. For China, this has meant large inflows of foreign direct investment and a rising share of total Chinese exports produced by foreign-related firms (See “The Experience in China,” p. 42.)
While this aspect of China's economy, like that of many other developing nations, may benefit the country and its overall growth, it does not necessarily translate into a competitive advantage for Chinese companies, thus further clouding the link between GDP growth and EPS growth. On the contrary, it suggests that the rise of developing world economies may have as profound an impact on companies based in developed nations as it does on emerging markets companies themselves. Indeed, in a world where companies and markets operate across national borders, ultimately it is global economic growth — not the growth of the country or market where a given company is domiciled — that determines the parameters of global EPS growth.
The weak link between a country's GDP growth and the EPS growth of companies domiciled there suggests that investors should not expect a free ride simply by investing passively in a fast-growing economy. The globalization process, however, does create the potential for higher returns by expanding the universe of publicly traded companies that may benefit from the rise of the world's developing economies.
How to Benefit
Over the past 15 to 20 years, the pace of market openings and reforms has increased dramatically across the developing world, leading not only to new investment opportunities, but also to a more attractive environment for investors. Prior to the late 1980s and early 1990s, a vast array of constraints, both practical and regulatory, kept most emerging equity markets largely closed to foreign investment. So-called country risk was an ever-present danger, whether in the form of political instability, corruption, or other intrinsic problems. In the past, one had to contend with the ever-present possibility of being “right about the company but wrong about the country.” Concerned about country risk, many investors avoided exposure to the emerging markets altogether.
Those who invested in emerging markets often did so for diversification purposes. For many years, emerging markets equities traded in highly segmented markets, each with unique return potential and risks. The idiosyncratic nature of these risks tended to dampen short-term correlations with both developed markets and other emerging markets, providing valuable portfolio diversification benefits. Today, however, the diversification benefit is smaller as correlations between the emerging and developed world have increased. (See “Emerging Markets and the Developing World,” p. 43.) Globalization has, in effect, created greater linkages among countries, causing the world's stock markets to move more closely together. Some would go so far as to argue that once you combine the higher historical volatility of the emerging markets with the now-higher correlation with the developed world, emerging markets should be removed from investor portfolios.
However, a side effect of this rising correlation is that the country-level risk has decreased substantially as a driver of the investment decision. (See “Country-specific Risk Factors,” p. 43.) So, while idiosyncratic country risk remains, the percentage of an individual stock's return that is attributable to its country of domicile has declined dramatically. Thus, to minimize risk, an investor should search across the widest possible opportunity set to find the best investment opportunities and control risk through prudent diversification across industries, sectors — and countries.
As active managers, we look for dispersion in the investment opportunity set in order to find companies that are positioned to outperform. For example, while consensus economic forecasts expect Spain to have the least GDP growth in 2010 and China the greatest, there is a wide range of forecasted earnings among companies based within each country. There are many companies headquartered in Spain whose growth prospects are better than companies domiciled in China. Likewise, while the P/E multiple of the Spanish market overall is significantly lower than that of the Chinese stock market, there are still many companies headquartered in China that are cheaper than those in Spain. (See “China and Spain,” p. 43.)
In the past, most investors who wished to invest globally determined geographic weighting first, then selected specific investments within those geographies. In an increasingly global marketplace, however, geographic weightings should be an effect — not a cause — of bottom-up stock selection. This may cause sector weightings to stray from geographical considerations. At the time of this writing, for example, Bernstein's global research team found the most attractive materials sector opportunities in emerging markets companies. But we see the best technology opportunities in the United States, while the best financials and telecom sector opportunities are in developed international countries.
While there is compelling potential in emerging markets today, the opportunities lie more in specific companies than in the markets as a whole — and these companies may be domiciled in emerging or developed countries. Due to the impact of ongoing market integration, investors should prepare for a world where exposure to stocks domiciled in emerging markets is simply the natural outgrowth of a global investment framework.
Our research suggests that emerging markets should represent, on average, between 5 percent and 10 percent of global equity investments based on their fair share of the global opportunity set and the investor's willingness to take on currency risk. Diversification across both stocks and markets will remain essential, as country-specific events can still produce disappointing outcomes.
Above all, investors should not overweight a country or region solely based on GDP growth expectations. Investment success will be determined by the ability to identify the companies that will benefit most from emerging markets growth and that will pass on those benefits to investors. Identifying these companies and investing in them successfully will be the result of bottom-up stock research that is truly global in scale and perspective.
Bernstein Global Wealth Management, a unit of AllianceBernstein, L.P., does not offer tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.
- Lipper, Strategic Insight, and AllianceBernstein.
- Here we show a comparison of per capita gross domestic product (GDP) growth to stocks returns, but the conclusion also holds for total GDP growth, which includes growth driven solely by population expansion.
Gregory D. Singer is director of research in the New York office of the Wealth Management Group at Bernstein Global Wealth Management