Bear Warning

Low Future Economic Growth and Expected Returns

Bear Warning

We have recently come across a series of articles that are giving warning about the near future of slowed economic growth, high levels of volatility, and potentially lower returns from stocks and bonds. Although the stories are compelling, we believe that investors should be cautious about translating these warnings into investment decisions. Further, although there may be a slow down in future economic growth over the short to medium term, which nobody actually knows with a high degree of certainty, future expected returns may not be as dismal as some authors are predicting.

NYU professor and economist, Nouriel Roubini, recently published a column titled The Global Economy’s New Abnormal in the free online publication for professional commentaries, Project Syndicate. In his column, Professor Roubini states, “the world economy in 2016 will continue to be characterized by a New Abnormal in terms of output, economic policies, inflation, and the behavior of key asset prices and financial markets.”

Similarly, Vanguard posted an article titled Investing is Not Alchemy: Facing Lower Returns where Chairman and CEO Bill McNabb and Chief Investment Officer Tim Buckley answer key questions they believe most investors are asking in 2016. Asked about Vanguard’s economic and investment outlook for 2016, Mr. McNabb states, “this will be the third year in a row where our outlook is a bit guarded for the next decade. We think returns over that time are likely to be lower than long-term historical norms.” Mr. Buckley adds, “because we expect lower global growth and lower returns, we hope people won’t be tempted by new investment fads to try to get extra return.”

There are many more economists and investment professionals who share the same sentiment. Some investors may feel compelled to take this information into their investment decisions since many professionals state their predictions as if it were already cemented in time. Unfortunately, potential lower global growth doesn’t necessarily translate into lower returns. In 2002, Elroy Dimson, Paul Marsh and Mike Staunton, authors of Triumph of the Optimists: 101 Years of Global Investment Returns from the London Business School found a negative correlation between investment returns and growth in GDP per capita across 17 different countries going back to 1900.  In other words, equity returns were higher when there was lower economic growth.

To give a very recent example, for the five-year period from 2011-2015, the Chinese economy grew by 7.7% annually1 but returned -1.36% annually (as measured by the iShares China Large Cap ETF, TICKER: FXI) in terms of equity returns. In contrast, the US economy grew by just under 2.4% but returned 12.43% annually (as measured by the SPDR S&P 500 ETF, TICKER: SPY) for investors.

How could this possibly be?

From a theoretical standpoint, higher economic growth shouldn’t necessarily translate into higher returns for existing shareholders. A possible reason is that the prices of stocks in high growth countries are bid up in anticipation for the potential of that higher economic growth translating into higher returns to shareholders. This is similar to how we think about growth stocks. Growth stocks are usually categorized by robust earnings and high capital investment. In other words, investors are relatively certain about the future prospects of a particular company. This is at least what we would expect in a competitive capital market.

In publicly traded markets, prices reflect a consensus about the future prospects for a particular company. We can use metrics like price-to-earnings or price-to-book value to compare companies across sectors about their future. All else equal, paying a lower price for a certain level of earnings or book value must either be a market “mispricing” or proper market pricing of the level of uncertainty around the ability to capture those earnings in the future.

Prices also reflect future prospects about global economic growth. If there is more uncertainty around the issues that Mr. Roubini suggests are going to be pervasive in the near term, then we would expect prices to drop in anticipation of that uncertainty. Nonetheless, the more grim the future outlook may look, the higher the required rate of return demanded by investors for bearing that risk.

It is essential for investors to understand the separation between economic predictions and the capital markets. A well functioning market will have prices reflect global sentiments. Historically, there has been a negative correlation between economic growth and market returns. Although these prognosticators may be correct in expecting lower economic growth in the future for a variety of reasons, investors shouldn’t necessarily expect these prospects to lead to lower returns. The markets have been through many cycles of economic boom and bust, and they have historically rewarded investors with a long-term mindset. Depending on specific goals, we can manage the amount of uncertainty we would like investors to be exposed to through the use of bonds. We believe this to be the best approach for investors in any type of future economic environment.



[1] Data provided by the World Bank