Does higher growth increase long-term stock returns? Via Investing.com

Long-term investors who incorporate macro factors and forecasts into their decision-making may be interested in the findings of a JP Morgan report released Thursday on whether economic growth leads to higher stock returns.

Intuitively, that there should be a correlation seems obvious, given that higher GDP growth should lead to higher earnings growth, which should in turn lead to returns higher levels of equity.

However, JP Morgan’s study finds that this is only true for developed markets, not emerging markets. In developed markets, analysts find that a 1 percent increase in economic growth is associated with about 3 percent higher long-term stock returns, on average.

They also pointed out that equity market caps in emerging markets are, on average, only a fifth of their GDP, while in developed markets they are 1.2 times GDP, which would explain the ‘disconnect’ between growth and emerging market equities.

In developed markets, the relationship explains about 25% of the variation in long-term stock returns; and the positive relationship with economic growth comes from earnings growth as well as P/E and FX earnings.

Despite the correlation between economic growth and yields in developed countries, however, “long-term growth forecasts come with large forecast errors,” so there is no relationship between forecast growth and actual yields. Furthermore, returns are also not related to recent past growth.

However, analysts do not believe this is a reason not to consider growth forecasts when investing.

“Great long-term investors must all make assumptions about the long-term future returns of the asset classes in which they invest. Our results suggest that these frameworks should take into account that higher growth in any country tends to go hand in hand with higher multiples and currencies,” they said.

The investment bank had previously forecast growth a decade ahead of 1.8% for the US, 1.4% for the euro zone and 0.8% for Japan. “Taking uncertainty into account, this is one factor that suggests the outperformance of US stocks can be sustained,” they said.

JP Morgan is also strategically underweight emerging market stocks over developed market stocks, but says it would have been wary of taking that position if long-term economic growth was indeed a useful signal in emerging economies.

Also interestingly, while theory would suggest that economic growth would already be priced in so that the “windfall” of growth contributes to returns, JP Morgan finds that there is a weak relationship between the two.

“Our main interpretation is that investors are either focusing primarily on short-term drivers of the markets and/or not giving much credence to long-term growth forecasts,” they added.