Things are seldom what they seem, Skim milk masquerades as cream

As an investor and wealth manager, I increasingly hear from investors and advisors alike that they ‘fancy’ or ‘like’ a specific country to invest in. Over recent years, the huge growth in capital in emerging growth economies in Asia and Latin America has persuaded many investors to invest heavily in these economies. But the prospect of economic growth is not the reason we should invest globally. In fact, it may surprise you to learn that there is a negative correlation between economic growth and returns from the stock market. This is true for countries in the developed and developing world.

The current trade war between China and the US and the relocation of some businesses from China to Vietnam and other Asian countries has caused investors to follow the money (although I have yet to find evidence for it at the level stated by Trump rhetoric). To allocate capital to countries with strong economic growth as reflected in their per capita gross domestic product (GDP, a measure of the economic output of a country relative to its population) would appear logical, but this rationale does not stand scrutiny. In fact, careful study of data shows that the opposite is true.

A country with strong economic growth as measured by per capita GDP does not produce a strong equity market. Quite the reverse is true. A study published by Dimson, Staunton and Marsh of the Credit Suisse Research Institute looked at the growth of real per capita GDP from 1900 to 2013 and found that countries with the best stock market returns had the lowest growth in GDP per capita. ‘Many investors and commentators have misunderstood the evidence on economic growth and equity performance’, concluded Dimson, Marsh and Staunton. China is perhaps the best example, with the MSCI China Index returning a paltry 1.50% pa to investors since 1992, in spite of their ‘reported’ GDP growth figures. (My emphasis on ‘reported’.)

This is counterintuitive, and it is beyond the scope of this piece to explore further this paradox. However, two observations should provide some clarity. First, in a strategy of buying the shares of countries that are advancing economically, the investor is actually buying companies that are on average becoming less risky, and hence offer a lower expected return. It is more risky to invest in distressed economies. in general, the expected return should be higher than expected returns in growing economies. Second, the stock market is a barometer, not a thermometer for an economy. Stock prices reflect the anticipated condition of business, and to some extent predict a country’s economic growth.

The reason we should allocate capital internationally and away from our domestic economy is to diversify a portfolio and reduce risk. Investors would be well served to apply this strategy and not chase profits in growth economies which are likely to disappoint.

Jeremy Blatch TEP
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