You are here: Home / Articles / How growth affects financial markets

How growth affects financial markets

Every investor should understand the relationship between growth and the return of different financial assets.

Economic growth is central to the performance of all asset classes and to the relative performance among different asset classes.

There is direct causality running from economic growth to growth in corporate earnings, to demand for commodities, to the outlook for in inflation, and to investor optimism. Understanding these linkages is key to developing a practical knowledge of investment. In this chapter I explain how economic growth affects the major asset classes – equities, bonds and commodities. We shall build on this knowledge as we develop the investment process.

Growth and equity markets

Figure 2.1 shows the link between economic growth, measured by world GDP growth, and the annual return of the MSCI World Index.

This chart shows a strong correlation between GDP growth and equity market return. Over the past 20 years, the correlation has been 54%.
Growth primarily impacts equity markets via corporate earnings, although there are other linkages via commodity prices, interest rates and sentiment.

Fig 2.2 shows the link between the US ISM Index and the annual growth in expected earnings for the MSCI World Index. The ISM Index is a gauge of US growth derived from a monthly business survey. It is widely regarded as the single best monthly proxy of global growth because the US economy is highly correlated with global growth.

The tight fit between economic growth and earnings growth exists because corporate sales reflect economic growth and because earnings are leveraged on sales. In other words, a small change in sales growth normally has a much bigger effect on earnings.

This linkage between growth and corporate earnings, and hence stock market performance, is fundamental and will never change. As far back as we have data; we can demonstrate a powerful link between growth and equity market performance.

Fig 2.3 plots the return of the S&P Index as far back as 1871, a history of nearly 150 years. Over this period the S&P has returned 4.5% per annum. The dark black line on the chart shows that an investor would have achieved an annualized return of 9.9% by avoiding stocks during periods of recession. The dashed line, by contrast, shows that the return during periods of recession was minus 8.3% annualized.

We have shown these respective returns using a log scale because otherwise only the return line when recessions were avoided can be observed. By avoiding stocks during every recession since 1871, an investor could have outperformed the S&P index 36 fold over the past 150 years.
Clearly, if we can anticipate economic growth, and especially if we can anticipate recessions, we should be able to greatly outperform the market.
Over the years many academics have argued that stock market performance is nothing more than a random walk and that the stock market cannot be timed. After reading this manual you will have no doubt that stock market performance is extremely mechanical, following very deliberate patterns and therefore can be timed. We just need to know how to measure growth.
Growth and commodities
The link between world GDP growth and the annual change in commodity prices retCommodity prices are leveraged to the global cycle in the same was as are corporate earnings. A change in GDP growth of just one or two percentage points can have a dramatic in

Leave a Reply

Your email address will not be published. Required fields are marked *