Should Investors care about the Economy?


By Monish Chhabra ǀ May 3, 2019

It is often suggested that a fast-growing country produces better stock market returns for the investors. We take a look here, at two such countries – China and India – which have both grown well over the last few decades.

In China, the economic reforms started in 1978. The goal was to move it from a closed, centrally-planned economy, to a more open, market-oriented one. It was in early 1990s that China increased its privatization efforts and global outreach. The stock markets in the mainland - Shanghai and Shenzhen – opened in 1990, after being shut down 40 years before.

In India, the stock market history goes back longer; Bombay stock exchange was Asia’s first stock exchange, opened in 1875. However, the economic policies were designed towards socialism and protectionism. Only in 1991, the economic reforms started in India. These included industrial de-regulation, financial liberalization, and reduced controls on foreign trade and investments.

The following chart shows the growth in the economies of China and India, from 1993 to 2018. This is nominal GDP growth, equalized at the start for both countries at $1.

Over the last 26 years, each dollar of GDP has grown to 32 dollars in China, and 10 dollars in India. While both countries did well, China’s economy grew 3-times more than India’s.

What that has meant for investors

The following chart shows the growth in stock market indices of China and India, from 1993 to 2018. The start is equalized for both countries at $1.

Over the last 26 years, each dollar in India’s stock market has grown to about 16 dollars, while it grew to only 3 dollars in China. This turns conventional wisdom on its head. China’s economy has grown 3-times bigger than India, and yet India produced 5-times more returns than China.

India’s stock return of 16 dollars, outpaced its own economic return of 10 dollars. While the country did well for its population in general, it created 60% more wealth for its investors. This can be the result of higher earnings growth of its companies, or rise in valuation, or both. Whatever be the factors, the outcome has been within the range of what can be expected and reasonable.

However, China’s stock return of 3 dollars is 90% lower than its own economic return of 32 dollars. The country did very well for its populace, however not much for its shareholders. To invest a dollar, wait 3 decades, bear all the volatility and then get back 3 dollars, is not much of a dream for an investor.

What next?

We delve deeper into the disconnect we observe in China. Below is the country’s GDP growth versus stock market returns, on the same chart. We use a logarithmic scale here, to better reflect the base effect and the rates of change.

1997 was a peak in China. The market fell hard after that, while the economy continued to grow well. By the time stock market bottomed in 1998, there was a big gap between the green line of the economy and the orange line of the stock market. A few years later, the market rose back to catch up with the economy. The orange line peaked close to the green line again in 2007.

2007 became the new peak. The market fell hard again. By the time it bottomed in 2008, there was again a big gap between the economy’s green line and the market’s orange line. This 2008 gap was roughly similar to the 1998 gap.

Here on, something changed in China. What followed in its stock markets after 2008, was very different from what happened after 1998, despite the economy growing well in both cases.

Even after 10 years of that 2008 bottom, the market has still not come back. The gap between the green line of economy and the orange line of the stock market, has grown so incredibly large, that 2018 looks much worse than the bottoms of 1998 or 2008.

This gap would narrow again, one way or another. Either the orange line would move up, or the green line would move down. And here is the crunch time for an investor.

If one believes, that the gap would close by the market’s orange line moving up, then this could be the opportunity of a lifetime. If the orange line rises and eventually comes as close to the green line, as it did in 1997 or 2007, the stock market could rise 10-times. That would be a spectacular opportunity to invest.

However, if one reckons that the gap would close by the economy’s green line moving down, then the GDP growth could really fall off a cliff.

Time would not solve this gap; what the economy shows, versus, what the market says. It has to resolve by one of them giving in to the other. And that would determine some momentous outcomes in China, over the next decade.

This write-up is for informational purpose only. It may contain inputs from other sources, but represents only the author’s views and opinions. It is not an offer or solicitation for any service or product. It should not be relied upon, used or construed as recommendation or advice. This report has been prepared in good faith. No representation is made as to the accuracy of the information it contains, nor any commitment to update it.