Background
Scholarly literature widely researches the link between economic development and equity returns, yet the findings are often inconsistent and vary by context. While it seems logical that higher growth should lead to better returns, this is not always supported by data. For example, Pan and Mishra (2018) found no significant correlation between these variables in the case of China.
Earlier studies show a mixed picture concerning the relationship between economic growth and stock market performance. Ritter (2005) indicated the relationship was complex in developed nations. Conversely, other research, such as that by Olweny and Kimani (2011) in Kenya and Paramati and Gupta (2011), demonstrated a clear, reciprocal relationship between the variables. Given these conflicting results, this paper seeks to clarify this inconsistent correlation.
Purpose and Rationale
The purpose of this paper is to determine if stock market performance and economic growth in emerging economies were correlated during the past 8 years. The study had two objectives, which were achieved using a quantitative analysis method. First, the study aims to determine if there is a significant correlation between GDP growth and annual market returns in Brazil, Russia, India, and China, collectively known as the BRIC countries. Second, the study aims to determine whether GDP growth over the past few years can be a significant predictor of future equity returns.
Previously, this subject was empirically studied by Henry and Kannan (2008). The study examined whether investment in emerging countries, such as the BRIC countries, was more profitable due to their higher economic growth rates. The results demonstrated that no correlation between economic growth measures, such as annual GDP growth rate, and market returns (Henry & Kannan, 2008). However, the results of this research were outdated, as they utilized data from before 2005. Additionally, investors must consider whether past GDP growth can be used as an indicator of a potential investment opportunity.
Context and Methods
BRIC is an acronym for the association among four countries: Brazil, Russia, India, and China. Although these countries are often referred to as developing, they are expected to become leading suppliers of manufactured goods, services, and raw materials globally. Even though these countries are often referred to as a group, they have not established coherent trade unions.
The critique of the organization is that it ignores the finite nature of natural resources, such as fossil fuels, uranium, and metals. However, the economies of the countries continue to grow, and, in 2014, 30% of the global GDP was accounted for by the BRIC countries (Majaski, 2022). Thus, investing in the stocks of these countries is an intuitive way to maximize returns on investment.
Two methods were employed to achieve the study’s two aims. First, annual GDP growth data were obtained from Refinitiv Eikon for the years 2013-2021. The period was identified by data availability. After that, annual equity returns were acquired for the same years, and Pearson’s correlation analysis was conducted. The correlation coefficient was calculated for both individual countries and all countries combined.
Second, BRIC countries, along with the US, the UK, and France, were ranked based on their average GDP growth between 2015 and 2018. Their average returns for the period between 2019 and 2021 were also ranked to determine if a correlation existed. After that, the results of the analysis were interpreted in light of the findings of previous studies.
GDP and Equity Returns
Data Description
GDP growth (Figure 1) varied significantly by country over the eight years under analysis, with notable differences observed from year to year. GDP growth of the countries under analysis varied between -5.9% and 7.7%, with a mean annual GDP growth of 3.05% and a standard deviation of 3.61%.
The distribution of GDP was slightly negatively skewed (Skewness = -0.5) and platykurtic (Kurtosis = -0.54). China had the most stable performance in terms of GDP growth during the past eight years, while other countries experienced significant declines in GDP during the COVID-19 pandemic. Additionally, Russia and Brazil experienced a significant decline in GDP associated with the Crimea crisis.
The equity returns of the countries under analysis (Figure 2) varied between -47.38% and 63.62%, with a mean value of 6.2% and a standard deviation of 25.89%. The distribution of the equity returns had a minor positive skew of 0.15 and a negative kurtosis of 0.17. Brazil’s stock market performance was the most volatile, as both the minimum and maximum equity returns in the period belonged to the country. The COVID-19 pandemic appeared to have a significant negative effect on Russia and Brazil; however, it had no evident effect on the market performance of China and India.
The data distribution indicates that the variability in terms of GDP, equity returns, and their trends was high. In other words, the group of BRIC countries appeared non-homogeneous in terms of the variables under analysis. Therefore, it may seem incorrect to group these countries due to their varying economic growth and equity returns.
Results
A total of five correlation analyses were conducted to determine if there was a link between return on equity and GDP. First, a Pearson correlation analysis was conducted for each of the BRIC countries separately. The results demonstrate that the correlation between GDP and equity returns (Figure 3) varied significantly among the BRIC countries.
While the correlation coefficient was positive for India, Russia, and Brazil, it was negative for China. In other words, data analysis demonstrated that the correlation between equity returns and economic growth was negligible for Brazil, Russia, and India. At the same time, the correlation coefficient for China demonstrated a low negative correlation (McClaive et al., 2018).
A correlation analysis was also conducted for the entire dataset, disregarding the country of observation. The analysis demonstrated a Pearson’s correlation coefficient of 0.28, indicating a negligible correlation. This implies that, overall, the association between equity returns and GDP in BRIC countries was statistically insignificant. The data was tested for normality, as it is a crucial assumption of correlation analysis. The analysis of descriptive statistics demonstrated that both skewness and kurtosis were in the range of [-2; 2], which implies the data were normally distributed (McClaive et al., 2018).
Additionally, the dataset was tested for linearity, a central assumption of Pearson’s correlation analysis. Linearity was tested by creating a scatter plot of GDP against equity returns for the BRIC countries and observing any potential patterns. The analysis of the scatterplot revealed no apparent patterns, and an overall slight positive trend could be observed. This implies that the assumption of linearity was not violated. The scatterplot is provided in the figure below.
Discussion
The data showed no reliable statistical relationship between equity and GDP in BRIC countries from 2013 to 2021. In other words, the correlation analysis revealed that the economic growth of BRIC countries was not connected with increased returns on equity during the past eight years. These results are in accord with the previous assessment of BRIC countries in terms of the correlation between the variables conducted by Henry and Kannan (2008).
Henry and Kannan (2008) conducted an empirical study using a simple linear regression model to determine if average returns for the year were affected by average annual economic growth of developing countries. The study demonstrated that the coefficient was insignificant, which aligns with the findings of this study. However, the previous study utilized the data for emerging economies between 1961 and 2003 (Henry and Kannan, 2008). Therefore, this study contributes to the current body of knowledge by demonstrating that Henry and Kannan’s (2008) findings remain valid in today’s reality.
While the evidence suggests that there is no direct link between GDP and equity returns in emerging economies, it may still be inaccurate to say that economic growth has no impact on stock market performance. As cited by Buttonwood (2011), it may be incorrect to measure the economic performance using GDP as an indicator of economic growth and equity returns as an indicator of stock market performance without adjusting the measures for currency fluctuations.
In other words, to ensure high returns on investment, an investor should look for “strong rate of real economic expansion, strong nominal pricing power and reflationary pressures and currencies that are either undervalued or at least stable on a forward-looking view” (Buttonwood, 2011, para. 4). Since the results of this study are not adjusted for currency fluctuations, there may still be a possibility that there is a link between economic growth and stock market performance of emerging economies. However, testing for such a correlation is beyond the scope of this essay.
The results of this study are reliable for three central reasons. First, the data was collected from a reputable source that carefully rechecks the collected information. Second, none of the assumptions of correlation analysis was violated, which implies that the results of the tests are reliable. Finally, the methods employed by the author were previously tested in research by Henry and Kannan (2008). However, despite the evident strengths of the approach, certain limitations should be acknowledged. While the conclusions drawn from the statistical analysis are based on robust data, there may still be issues associated with the reliability of findings.
Specifically, some previous studies have employed more complex methods to investigate the relationships between economic growth and stock market returns. For instance, a study by Pan and Mishra (2018) used a unit root test with two structural breaks and an autoregressive distributed lag (ARDL) model to test similar hypotheses. Additionally, the findings of the statistical analysis have limited generalizability, as they are reliably applicable only to BRIC countries and cannot be extended to all emerging economies.
The analysis presented in this essay suggests that it is impractical to use GDP projections to determine whether investing in the country is worthwhile. This phenomenon may be due to investors using historical data to predict the country’s future GDP growth performance. In other words, if investors see that a country demonstrated a good performance in terms of GDP growth in the current year, they are more likely to invest in the country’s stocks next year. As a result, there may be a lag in the relationship between GDP growth and equity returns. In other words, GDP growth may have a long-term effect on stock market returns.
If GDP growth is an indicator of stock market returns in the same year, the information itself may be useless for investors, as they would need to find a reliable forecast for GDP growth in the countries of interest, which may be very challenging (Buttonwood, 2011). Moreover, investors would also need a reliable forecast for currency fluctuations to adjust both GDP growth and equity returns for changes in currency values. Therefore, it is essential to investigate whether a country’s historical GDP performance has a significant impact on its equity returns. This question is discussed in this essay below.
GDP Growth Effect on Equity Returns
To test if GDP growth had a prolonged effect on equity returns, it was decided to collect data about GDP growth for seven countries, including BRIC countries, the US, France, and the UK, and test if the average GDP growth of these countries between 2015 and 2018 had an impact on the average equity returns for these countries between 2019 and 2021. It was assumed that an investor would examine the GDP growth rates of a country and decide to invest in a portfolio of the top three performers from the selection for three years. The outcomes of the scenario were compared to investing in the bottom three performers in terms of GDP growth.
Data Description
The data concerning GDP growth for the seven countries are provided in Figure 5. Descriptive statistics for the dataset were not calculated, as no statistical tests were conducted.
The description of the data demonstrates that France and China were the most stable performers in terms of GDP growth between 2013 and 2021, while the GDPs of other countries were associated with increased volatility. The economic growth of almost all countries was affected by the COVID-19 pandemic, with the UK being hit the hardest. Figure 6 demonstrates the changes in equity returns by country between 2013 and 2021.
The graph of equity returns shows greater volatility compared to GDP growth changes for the same period. The graph illustrates that the most impactful years in terms of equity returns were 2014, 2016, and 2020, which were associated with the Crimean crisis, Brexit, and the COVID-19 pandemic, respectively.
Scenario Analysis
According to the designed scenario, to inform an investment decision, an investor calculated the average GDP growth of seven countries—Brazil, Russia, India, China, the US, France, and the UK—for the period between 2015 and 2018. After GDP was calculated, the countries were ranked accordingly. After that, the average equity returns were calculated for the countries for the period between 2019 and 2021, assuming the investor made a three-year investment. The results of the calculations are provided in the table below.
Table 1. Average GDP growth between 2015 and 2018.
The analysis revealed that, in terms of GDP growth, India, China, and the US were the top three performers, while France, Russia, and Brazil were the bottom ones. Therefore, according to the proposed scenario, the investor should invest in stocks of India, China, and the US. Such an investment would yield an average annual return of 15.48%, assuming the investor distributes the investment equally among three countries. At the same time, if the investment was made in the bottom three in terms of GDP growth, the average annual return on investment would be 5.59%.
Discussion
The results of the analysis suggest that GDP growth may have a notable effect on equity returns over a prolonged period. In particular, the analysis results demonstrated that investing in the top three performers in terms of GDP growth between 2015 and 2018 was associated with significantly higher returns compared to investing in the lowest-ranking performers in terms of GDP growth for the same period. This may suggest that investors can use historical data on GDP growth to inform their investment decisions in BRIC countries and more developed markets.
The results of the analysis contradict the previous findings. Credit Suisse (2011) conducted a similar analysis, using records from 83 countries from 1972 to 2009 to rank them by GDP growth over the previous five years. After that, they invested in five countries with the highest economic growth during this period. Such a strategy yielded an annual return of 18.4%, whereas investing in the lowest-growth countries yielded a return of 25.1%. This indicates that no correlation was found between historical performance, as measured by GDP growth, and equity returns (Credit Suisse, 2011).
There are two possible explanations for the inconsistency. On the one hand, reality may have changed over the past eleven years, and historical performance in terms of GDP growth may now have a greater impact on equity returns. On the other hand, this analysis may be biased due to limitations. This study had a smaller sample, including only seven countries with data for only seven years, whereas the study by Credit Suisse (2011) included a sample of 83 countries spanning 37 years. Additionally, the study was conducted by a group of experienced professionals, whereas one person with relatively limited experience wrote this paper. As a result, the results of this study may be biased.
Further Considerations
Another investment scenario was considered for years between 2019 and 2021. In particular, the possibility of investing in the BRIC countries was compared with that of investing in the developed markets of the UK, France, and the US. The investment in the BRIC countries yielded a mean yearly return of 10.16%, while investment in the other three was 9.19%. Thus, even though investment in BRIC countries could lead to higher returns, the 1% difference is not a significant one.
Conclusion
Analyzing data from BRIC countries between 2013 and 2021, this paper explored the relationship between GDP growth and equity returns. Surprisingly, the analysis showed no significant correlation between them, a result consistent with earlier empirical research. However, when testing for long-term effects, the study found that a country’s current GDP performance may predict its future equity returns.
References
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