Stock markets are not economic reality

Equity cycles have some relationship to GDP growth, but they are also dependent on central banks’ policies, lending by commercial banks – and on investors’ ever-changing view of the future.

| 4 min read

Market commentators and forecasters spend a lot of time trying to predict what will happen to economies – and therefore to turnover and profits of companies to try to predict stock market movements.

It is broadly true that, if people expect rising growth and profits to be sustained for the future, markets will be bullish. If a recession starts to loom a bear market might set in. It does not mean, however, that fast-growing economies always have better stock market performances than slow growers. Nor does it mean that total stock market values by country necessarily reflect the relative size and growth of economies.

US equities now account for 66% of the total value of quoted world shares, as measured by the MSCI World Index of the advanced countries. If you take the All World Index, which includes more of the emerging world, the US proportion is still a dominant 58%. Japan with the second-largest stock market weight (6%) followed by China (5%) and the UK (4%). Today, the US is around one quarter of world output and has less than 5% of the world population.

China under-represented

China, as the world's second largest economy, still has a small proportion of total world shares. Part of this is because much of Chinese industry and services are still nationalised, and other parts are in unquoted private-sector businesses. It is also because the Chinese stock market, unlike in the US, has been performing badly over the longer haul.

The Shanghai main Index is currently at 3,400. It reached a peak as long ago as 2007 at more than 5,500. It hit another lesser high of 5,166 in June 2015 when excessive credit and broker loan growth fuelled a bubble. Since those peaks, China has not been given any credit for the long run of years offering fast overall growth. Between 2006 and 2018 growth averaged just under 10%, and over the last few years it has been around 6% apart from the pandemic year, when there was still an advance in overall output.

Part of this reflects the fact that the authorities have been keen to learn from what they regard as periods of excessive price performance in 2007 and 2015 and have kept stock market credit under more control. Part of it is western suspicions of Chinese actions and governance, reducing the flows of western money into Chinese markets and keeping valuations down. Part of it is the higher share of old economy activities in the Chinese index.

Brazil market fiesta

There is a marked contrast with Brazil. Brazil has not been able to sustain fast growth on a reliable basis like China. Periods of good growth have been interspersed by nasty downturns. In 1980-81, in 2015-16 and last year there were deep recessions, whilst years like 1990 and 2009 also saw negative figures.

Despite this, and a lower overall growth rate than China, the Brazilian stock market has been making fresh highs in recent years. In March 2018, in January 2020 and again this year the Bovespa Index has hit new records, well above the historic levels seen at previous peaks in 2008 or 2014.

Whilst equities are about growth in turnover, earnings and dividends for companies, individual stock markets do not have a simple correlation with aggregate growth. The Japanese share market has never got anywhere near the extreme high reached in 1989 in the three decades that followed, despite respectable per capita GDP growth since.

The US market, thanks to its strong technology companies has marched onto a series of new highs in recent years. The French and Spanish markets have not exceeded their previous highs this cycle. The French market’s long-term high was reached in July 2000. The current high has just edged ahead of the 2007 peak.

Spain is more than 40% below its 2007 peak. It is true that Italy which has experienced a very poor GDP performance this century has a stock market around one half the peak it reached in 2000 in part reflecting the absence of any growth.

Equity cycles have some relationship to growth, but they are also dependent on central banks’ money policies, commercial banks’ lending policies, and on the ever-changing perceptions of the underlying prospects by worldwide investors.

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Stock markets are not economic reality

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