Economics Or Markets - Which One Leads the Other?

In this article we consider some basic information in the context of economics and markets. A key measure of economic growth is Gross Domestic Product or GDP (see Glossary). On the other hand, a key driver of share prices is Earnings Per Share or EPS (see Glossary). Why does this discussion even matter? There are many investment decisions made every moment of every day somewhere in the world. Those decisions broadly consist of two main inputs: economics and markets. In the context of economics, GDP forecasts are key. In the context of markets EPS forecasts are key. There are times in investment cycles when changes in GDP will provide greater clarity for investment decisions, and at other time, EPS guidance will provide greater clarity. Professional investors rely on one or the other measure to a greater degree, while most sound investment decisions rely on a view on both. Comparing the relationship between stock market returns and GDP growth, the charts below demonstrate the fact that it is EPS growth rather than GDP growth that drives stock returns. Investors who chose to invest in markets based purely on their GDP growth profile, would have clearly opted for emerging markets (China, India, Brazil, Russia for example). Whereas developed economies displayed lower GDP growth. Emerging economies have underperformed developed economies for the last year despite their respective GDP profile. The reason is that EPS affects share prices despite the wider economic growth output. GDP growth does not drive stock market returns...

Note: Data for 38 counties for period 1981 2009 or since data available Source: Haver Analytics, MSCI Barra

Earnings growth does

Note: data for period February1991 to January 2011 Source: Haver Analytics, MSCI Barra

At this point (July 2011) in the cycle, there is diverging GDP growth and EPS growth. In some nations GDP is shrinking, or being revised down, while EPS remains robust and earnings revisions are a net increase. Not so for Australia. FY11 and FY12 earnings estimates for the ASX200 continue to drift down. FY12 estimates still look optimistic given that the business environment (and therefore GDP estimates) in Australia remains challenging. While the market is conservatively valued, there is little to enthuse the marginal investor if earnings remain under pressure and the policy environment restrictive.

Glossary: Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country's borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory. Earnings Per Share (EPS): The portion of a company's profit allocated to each outstanding share. Earnings per share serves as an indicator of a company's profitability.