The Economy is Not the Stock Market
Key Takeaways
Economic calls such as recession announcements are usually lagging. E.g. For Japan and the UK, the recession call made in Feb 2024 only reflected data reported from Oct to Dec 2023.
Research shows that for both developed and emerging economies, there is no clear pattern that links market returns with the economy, i.e.
Positive market returns can occur when GDP growth is negative.
Negative market returns can occur even if GDP growth is positive.
GDP reports and recession calls are just one of many data points and indicators to consider in investments. We prefer to use hard data and an evidence-based approach which allows us to make the best decision for the investment management of the portfolios.
What do you call an economist with a prediction? Wrong.
Recent news about the UK and Japan slipping into a recession at the end of 2023 may have come as a shock to many.
Japan slips into recession, loses spot as world’s third-largest economy.
— The Straits TimesRecession has struck some of the world’s top economies
— AP News
The stock markets of both countries did reasonably well in 2023, (Japan — 17.2%, UK — 12.2%, shown in chart below), so it might be a surprising fact to note that the stock market performance did not reflect this decline in the economy.
This highlights a few significant points. Economic calls such as recession announcements are usually lagging. In this instance, the recession call was made in Feb 2024 to reflect data reported from Oct - Dec in 2023. As such, this announcement is around 4 months too late. There are other much more appropriate instruments and tools (which form part of our investment inputs) that provide more timely information regarding economic data. For example, the GDPnow model run by the Federal Reserve Bank of Atlanta gives a “nowcast” of official growth estimates using a quantitative model. As you can see from the diagram below, the estimates are usually quite different from economist forecasts which are typically lagging.
As for equity investors, not everyone is a day trader. The world market is made up of millions of investors, all with different investment time frames making buy and sell decisions. Some are looking at returns in the days and months ahead. Some are looking out 5, 10, or 20 years down the road. As such, the decline of these stock markets in 2022 could have already reflected their expectations of a slowdown in the economy, and the surge in 2023 could reflect the subsequent expectation that the economy is likely to improve in the years ahead.
Another point to note is that a period that could be defined as a recession in one country, may not necessarily pass as a recession in another.
In the diagram above, you will see that the US economy is driven primarily by the services sector (77.6% of GDP). The services sector produces a wide variety of goods — anything and everything from housekeeping, to rock concerts, to brain surgery. The industrial sector is primarily manufacturing — i.e. producing cars or machines. Contrast this to other countries such as China or India, where industrial production or agriculture forms a larger portion of the economy.
As such, a recession (defined as two quarters of declining GDP) in a particular country which could have been caused by declining manufacturing activity, may not necessarily affect another economy driven by services.
For Japan; its economic contraction was caused primarily by lower spending by its citizens, and for the UK, whilst it was also caused in part by lower spending, other factors such as a healthcare sector strike and declining school attendance were more significant in its economic contraction.
So if you are worried that a lower GDP number could contribute to lower stock market returns, fret not.
In a long running dataset (diagram above) which shows stock returns vs GDP growth of the US, there are periods where high economic growth coincided with good stock returns (yellow box). Then, there are other periods where low economic growth also coincided with good stock returns (purple box). So there is no clear correlation that positive stock returns must go hand in hand with good GDP numbers.
In another illustration which differentiates both developed countries and emerging countries (diagram above), the annual equity market return (y-axis) is plotted against the annual GDP growth of a country (x-axis). You will notice that for both developed and emerging economies, positive market returns occur whether or not GDP growth is positive or negative. What is more interesting is that negative market returns also occur even if GDP growth is positive. There is no clear pattern to linking market returns with the economy.
As such, GDP reports and recession calls are just one of many data points and indicators that one can consider to make an informed decision about investing. Sometimes the stock market takes its cues from the economy, and sometimes it doesn’t.
As for what will happen to the economy in 2024, we really cannot predict with good accuracy what could happen. Even if you knew exactly what would happen with the economy this year, it probably wouldn’t help you guess what the stock market would do.
At GYC, we prefer to use hard data, and a weight-of-the-evidence approach to guide the investment management for your portfolios. If you would like to know more, or are just worried about how a possible recession could impact your finances, come and speak with us.
