2014 has started with a torrent of bad news for Australian workers and manufacturers. The closure of Holden and Toyota’s local operations and the demise of Alcoa speak loudly about growing unemployment and an uncompetitive Australian manufacturing industry. Australia’s economy is slowing down and dire predictions by a leading economist of GDP growth as low as 1.5% in 2015/2016 could be taken as a sign that the Australian share market isn’t a great place to invest. Thankfully the evidence shows that quality companies can and do continue to prosper even when the national economy weakens, so it’s important investors allocate their assets towards companies with these solid fundamentals.
Writing in mid 2013, Bank of America/Merrill Lynch Chief Economist Saul Eslake stunned the market with his prediction of a big slowdown in the Australian economy:
“We attach a ~75% probability to a scenario in which Australian real GDP growth slows from around 2¾% p.a in 2013 and 2014 to just under 2% in 2015 and 1½% in 2016. In this scenario the unemployment rate peaks at 6¾% in early 2016.” (Source: BOA/ML 18 June 2013)
Saul Eslake is one of the most credible economists in Australia and – if correct – his statements could be interpreted by some investors as an indicator that they should be wary about investing in the Australian stock market. So what does the data show?
What is the link between the economy and stock market returns?
Thankfully for stock market investors, the data shows that there is (at best) a weak link between economic growth and stock market returns. This can be thought of in a couple of ways:
- Intuitively, it’s easy to understand that a strong stock market which reaches the point of “over-heating” may (and often does) coincide with an economy that is close to a recession – especially if official interest rates are rising rapidly in response to asset price bubbles and inflation.
- Conversely, a weak economy may be conducive to a strengthening stock market, as investors begin to realise that economic factors are improving – especially if official interest rates are low in response to the need to stimulate economic activity and inflation.
- It’s clear by looking at the low correlation in previous market cycles between GDP and stock market performance, that stock prices and economic activity rarely show strong correlation. This is typically thought of as reflective of the intuitive ideas in the previous point, but also is supported by financial theory.
In the exhibit below, we can see that between 1970 and 2012, there was a massive divergence between US GDP growth and US stock market performance. The observed correlation between those two factors was very low – for example, when US GDP growth was 1% p.a, stock market returns ranged between +15% and -12%.
Good news for fundamental investors
Quality companies know how to make money in good times, and in bad. A great example of this can be seen in the stellar performance of the Australian banks during and after the GFC, with each of our major banks posting rising record profits during these years.
Investors focused on market sentiment would have missed out on these returns, because of their fear that the market remained prone to a correction. But by focusing on fundamentals, investors at that time might have formed a rational view in favour of buying the banks, because of the quality of their earnings and the sources which produced them.
BetaShares is the issuer of the BetaShares FTSE RAFI Australia 200 ETF (ASX code: QOZ). The Index which this ETF seeks to track uses fundamental factors to weight the top 200 stocks on the ASX (i.e. rather than market capitalisation). The methodology utilised by this Index seeks to avoid one of the inherent biases of traditional market capitalisation weighted indices – which tend to overweight stocks that may be overvalued (i.e. stocks that are ‘overheated’ due to price speculation). Instead, the index methodology derives its constituents by focusing on longer term company fundamentals (i.e. strong cash flow, sales, dividends and book value).