Canada's gross domestic product has been all over the map. Our economy contracted in the second quarter, but it's growing in the third. Despite these fluctuations, the S&P/TSX Composite Index is soaring, up 16.5% over the first 10 months of the year -- its best performance since 2010.
Why is our market roaring when our economy is not? It's because GDP growth and stock market gains have little to do with each other, at least over the short-term. In fact, if you look at the Canadian market and our economy over a two-year period, the correlation between the two is almost zero, says Brendan LaCerda, an economist with Moody's Analytics. "More recently, there's been a breakdown in the relationship between GDP and stock markets," he says.
Many proponents of top-down portfolio management love to talk about GDP and markets as if one has a direct impact on the other. You might hear this from emerging market managers, who often say the main reason to invest in developing nations is because of economic expansion. Yet one of the best-performing equity market so far this year is Brazil, which is in a recession. The MSCI Brazil Index is up by 49% year-to-date as of Oct. 31, while its economy is expected to contract by 3.3% in 2016, according to the International Monetary Fund (IMF).
Clearly, the relationship between the two numbers is more complicated. "Faster growth can impact markets, but it's not a forgone conclusion," says Drummond Brodeur, global strategist with Signature Global Asset Management. "Markets rise on more than just GDP."
Long-term correlation
Over longer periods, there is a positive relationship between GDP growth and stock markets. LaCerda finds that between 1985 and 2016, there is a 0.40 correlation between the quarterly percentage change in GDP and the percentage change in the S&P/TSX Composite Index. Bob Johnson, director of economic analysis at Morningstar, has also found that GDP and stock markets are correlated over time. However, he says, economic growth is not a leading indicator of stock market growth -- it's the opposite. "The stock market is a darn good forecaster of GDP growth," says Johnson.
Since 2010, the S&P 500 Total Return Index has seen four peaks and four bottoms. In every case, the market switched direction between two and five quarters before GDP numbers did, says Johnson. Growth never leads markets, because economic data is backward looking -- Canadians received August GDP data in November -- and everyone gets the same data at the same time. It's too late to act on the numbers when they come out.
With that in mind, you could argue that retail investors, and many professional ones, spend too much time discussing growth numbers. "As Fidelity's Peter Lynch once said, if you spend 13 minutes a year on economics, you've wasted 10 minutes," says Johnson.
Predicting earnings growth
However, GDP can't be ignored. While investors shouldn't buy or sell on GDP news itself, a growing economy often results in higher profits and earnings for companies, which is essential to stock market growth. Johnson finds that when corporate profits increase, markets perform twice as well as when corporate profits are falling. Also, profits usually rise when GDP expands. If you think a country will experience solid GDP growth over several years, then you might also expect company earnings, and therefore markets, to rise.
Growth numbers can come in handy when trying to determine the influence of other economic factors, such as interest rates, which have a greater impact on markets. When the economy is accelerating, credit demand tends to rise while savings rates fall, as people borrow money to buy goods, says Brodeur. More credit and, therefore, more money in the economy can drive rates higher, he says. In slower economic conditions, people tend to use less credit and put their money into financial assets, like stocks, which then pushes markets higher. "You want to look at these linkages," he says.
There is one scenario where markets and GDP numbers are more closely tied. A rapidly falling stock market, like we saw in 2008, can drag an economy down with it. "A significant contraction in asset values can trigger a much more significant contraction in economic activity," says Paul Harris, president and portfolio manager at Avenue Investment Management.
Fundamentals first, economics second
When it comes to investing, Brodeur and Harris say a bottom-up approach is more effective than a top-down approach. Harris looks at things like a company's balance sheet, earnings growth potential, whether earnings are being driven by organic growth or acquisition-driven growth, company cash flows, whether it has a dividend yield, and more. Brodeur looks at all of these things, too. For him, though, one-third of an investment decision is driven by macroeconomic factors, while two-thirds is based on company fundamentals.
Brodeur is less interested in current GDP numbers. However, he does want to get an idea of where growth and interest rates are headed and how credit markets look. "If we see healthy credit markets backed by supportive monetary policy and stronger economic growth, then we'll see stronger earnings growth," he says. "There's a great interdependency between these things."
Harris doesn't care much for the GDP figure itself, but says the breakdown of the numbers can tell an important story. In the United States, consumer spending accounts for most of the country's GDP growth, while other sectors have not fared as well. This is useful because if consumers are spending, you might decide to invest in, for example, consumer discretionary stocks. If you invest based on GDP data as a whole and buy into a sector that's not expanding, you might not get the earnings growth you expected.
As much as we like to talk about GDP, investors shouldn't overweight these numbers in their investment decisions. Having a view to the future can be useful, but markets will rise and fall regardless of the current economic numbers. "Timing your investments on published GDP data is useless," says Johnson. "It's the stock market that will indicate where the economy is going."
