Are Economic Forecasts Relevant?

Since the GFC, many countries around the world have been focused on strategies to control and reduce their annual budget deficits.  In more recent times our Treasurer, Joe Hockey, has made this a prominent issue in Australia as the unsustainability of current Government spending programs becomes more evident.

But should investors focus on factors like a country’s budget deficit or economic growth forecasts when deciding where to invest?  The short answer is no.

Expected stockmarket and bond market returns are determined by risk, not by Gross Domestic Product (or GDP, which is the total dollar value of all goods and services produced by a country) or economic growth, which is how much GDP rises or falls each year.

 Whilst we have known this for a long time, a recent piece of research further demonstrated this fact.

The research focused on the major developed economies over the 40 year period 1970 to 2010.  Based on the actual real (i.e. after infaltion) 12 month GDP growth each country achieved, countries were placed into one of three groups – high, medium and low growth countries.  So a country could switch groups annually based on what its actual GDP growth was relative to other countries.

So imagine each year – with perfect 12 month foresight  – you managed a stock portfolio holding the high, medium and low growth countries.  Which portfolio did best over the 40 year period?  The graph below shows the results:

 

Source: Dimensional 11 April 2014

As one can observe, stockmarket returns are not reliably higher for high economic growth countries compared to low and medium growth countries.  In fact, the medium growth countries performed best, and for long periods of time high growth countries were the worst performers.

There are a couple reasons why this outcome is not unexpected:

  • For stocks, when the price is low, risk is high and so too is the expected return.  The same principles can apply to a country – remember stockmarkets are forward looking.
  • Over the 40 year period, the stocks in each country would have increasingly sourced their earnings globally, not just from their home market, due to the impact of globalisation.  A few years ago it was shown that for the 500 largest listed companies in the United States, 48% of their earnings were derived offshore.

At APW Partners, when we construct broadly diversified portfolios for our clients, we focus on a country’s market capitalisation (or the size of a country’s stockmarket) rather than its GDP when determining country weightings.  This is important because choosing to weight portfolios based on GDP would have a profound difference on the composition compared to an approach using market capitalisation, as the table below demonstrates:

Source: Dimensional 11 April 2014

A decision to construct portfolios based on GDP would increase the weighting to Emerging Markets substantially, in particular to China and India, and exposure to the United States would reduce by more than half.

But Emerging Markets have their own unique risk characteristics, with four defining traits:

  • High expected returns & high volatility
  • Political & economic risk
  • Liquidity concerns
  • Restrictions on foreign investment

For these reasons, we restrict Emerging Markets to around 20% of the total International share exposure to ensure the overall risk/return profile of our client portfolios is appropriate.

Consequently, when you read about various countries that are going through recessions or hard economic times don’t necessarily dismiss them as an investment opportunity.  Greece’s issues in 2011 and 2012 are well documented, but in 2013 its sharemarket was up 50.2% and in 2014 it is one of the best performing European stockmarkets.

As we talk to advisers and regulators around the world, it’s becoming more apparent that the glory days of traditional forecasting active management, stock picking and market timing (including trying to pick countries expected to outperform) are either already in the past or quickly being relegated to history. 

In its place, well informed investors are setting long-term objectives with appropriate risk constraints within a strategic portfolio structure to help them achieve their lifestyle and financial goals.

Author: Rick Walker & Greg Keady

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.