Emerging Markets – High GDP not equal to High Stock Returns

emerging marketsThis article is Part 1 of a 3 part series on Emerging Markets Exposure: Where & How Much?  Emerging stock markets appeal to investors for several reasons, the most frequently cited being their rapid economic growth. The allure of emerging markets can be strong, as faster economic growth is typically associated with stronger earnings growth, which many investors associate with higher stock returns. However, this assumption is wrong. Across 16 major markets, there is zero cross-country correlation between long-run Gross Domestic Product (GDP) growth and long-run stock returns. Higher GDP does not translate to higher stock returns. In fact, countries with slower growth have historically produced higher stock returns.

Related GDP Growth To Actual Returns Using 100 Years Of Data For 19 Different Countries

      (Source:  Study By Goldman Sachs)

Investor Action

Relative Annual Under-Performance Vs. “Slow Growers”

Invest Only In Countries With Lowest GDP Growth


Invest Only In Countries With Highest GDP Growth

– 3%

Invest Only In Emerging Markets

– 5%

Emerging Markets: Why Relative Performance Varies From Relative GDP Growth

Looking at individual country GDP data in isolation gives us zero insight into the potential merits of investing in emerging markets. Our investment decision process must be driven through other considerations. We believe there are four key factors that provide insights as to why relative stock performance between emerging markets and developed markets varies from their relative GDP growth. Understanding these factors help us determine where to have emerging markets exposure and how much.

Four Key Factors That Help Us Determine Emerging Markets Exposure 

1. Valuation –   What Is The Relative Discount For Emerging Markets Stocks?

We pay attention to valuation metrics such as price/earnings (P/E) ratios. Expected economic growth is built into current prices. Disappointments hurt. Upside surprises help. For example, when Japan’s Nikkei 225 soared to almost 39,000 in December, 1989, investors were overly bullish about Japan’s economic prospects and the valuations for Japanese stocks were extremely high. When that growth did not materialize, the Japanese stock market collapsed. A recent stock out-performance happened here. The U.S. was a “bad story with a good price” in 2008-2009, and turned out to be by far the best investment over the last three years.

2. Growth Surprises – How Much Does A Country’s Actual GDP Compare To Its Prior Market Expectations?

The correlation of unexpected changes in annual GDP growth with annual emerging market returns is a statistically significant 53%. For example, in 1993 Brazil’s stocks were relatively cheap because its economy had high debt, hyperinflation, and political instability. Brazil’s government managed to turn it around, much to the surprise of most, and its stock market took off. To be a lucrative investment at this time, China would need to grow even more than the 7.7% GDP that is already priced in to its stocks.


Emerging markets out-performed in 2005-2009, not from high economic growth, but for two reasons:

  • Equity valuations were low in the 2000s as compared to developed markets (valuations were attractive).
  • There was higher-than-expected growth during much of this period (there was a growth surprise to the upside).

Emerging markets under-performed in 2009-2013, not from high economic growth, but for two reasons:

  • Equity valuations became high (identical to the U.S., which eliminated the risk premium for investing overseas).
  • There were no “surprises” regarding economic growth (it was expected, or “priced in”, to be high).
MSCI Index (as of 03/31/14) YTD* 1 Year* 3 Year* 5 Year* 10 Year* Current Forward P/E**
USA 1.69% 21.30% 13.98% 20.51% 6.96% 15.4
EAFE (Europe, Australia, Far East) 0.66% 17.56% 7.21% 16.02% 6.53% 13.3
Japan (5.61%) 7.53% 5.38% 10.35% 2.19% 14.1
Emerging Markets (0.43%) (1.43%) (2.86%) 14.48% 10.11% 10.2
China (5.87%) 2.20% (1.70%) 10.36% 12.09% 9.0
Brazil 2.80% (13.00%) (13.03%) 7.84% 14.88% 10.0
India 8.16% 6.74% (4.62%) 15.44% 11.99% 14.1

*Annualized Performance                                                                    **Source: JP Morgan

3. Globalization – How Much Is The Emerging Markets GDP Growth Fueled By Foreign Investment?

Growth in emerging markets is significantly financed from abroad. U.S. corporate profits derived from direct foreign investment income doubled from 20% in 1999 to 40% in 2008. Historically, one third of foreign earnings have come from direct U.S. investment in emerging markets (source: Bureau of Economic Analysis). Developed markets contribute to emerging market growth but receive no GDP credit themselves. A U.S. company building a factory in China and selling to Chinese consumers will add to China’s GDP, won’t add to U.S. GDP, but can increase the U.S. company profits. This shows how the one-year stock performance between “developed U.S.” and “emerging China” (21.3% versus 2.2%) can inversely vary from relative GDP growth (2.5% versus 7.7%).

4. Interest Rates – Are There Current Or Anticipated Future Adjustments To Interest Rates?

Capital flows from developed markets to emerging markets can easily be reversed given sufficient interest rate enticement. For example, the 10-Year U.S. Treasury rose 128 basis points (1.76% to 3.04%) in 2013. U.S. investments got pulled from projects in Brazil and economic development in Brazil was negatively impacted. Over the last 12 months, the U.S. stock market was up 21.3% and the Brazilian stock market was down 13.0%.

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