GDP Growth and Equity Returns Australia and Canada

8/2/2019 GDP Growth and Equity Returns Australia and Canada

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THOMSON REUTERS 2012 31ST QUARTER 2012

A WICKSELLIAN EXPLANATION OF

WHY CANADAS STOCKMARKET HAS

OUTPERFORMED AUSTRALIASBy Thomas Aubrey, Managing Director, Fitch Solutions

The debate as to whether real GDP growth is a good indicator o equity market perormance remains

unresolved. Some market participants argue that there is a strong relationship between real GDP

growth and earnings growth, hence higher equity prices. Others argue that given there is little

correlation between the two fgures over longer time periods, this cannot be the case.

One issue in using real GDP growth signals as a barometer or equity market perormance is that theyare a product o current monetary economic theory and, given recent events, ought to be treated with

greater scepticism by investors. At a very simplistic level, the current theory states that i output is able

to grow without ination then this generates higher-than-expected profts, in turn sending up equity

prices. Unortunately, during the period o the Great Moderation this growth took place at the expense

o increasing leverage and hence was not sustainable, leading to a crash in equity prices and investors

losing money. Indeed, despite stockmarket rises rom March 2009, key equity benchmarks are still 15%

down on where they were at the onset o the fnancial crisis.

Another potentially more ruitul approach in trying to understand the dynamic o equity returns is

to use Knut Wicksells monetary theory, which is based on the notion that credit drives capital values

(equity). This article uses data rom Australia and Canada to test Wicksells idea given both countries

have strong growth rates but diering equity perormance. It highlights that Canadas stockmarket has

largely outperormed its Australian counterpart over the last fve years due to the dierence in leverage

ratios across the respective economies.

Canada and Australia: a tale o two countries

Two countries that have escaped the worst o the crisis with reasonably robust real GDP growth rates

are Canada and Australia. As a result, one might have expected equity markets in Australia and Canada

to have outperormed their peers. Unortunately, the data reveals that the relationship between real

GDP growth and stockmarket perormance is not consistent. Chart 1 shows that over the last fve

years, Australias real GDP growth rate has outperormed Canadas (let-hand axis), but its relative

stockmarket perormance has been lacklustre. Equity markets in Canada as well as the USA have

both signifcantly outperormed Australia in the last fve years (right-hand axis). However, as real GDP

FEATURE


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growth ell in 2008 across both countries, so did their stockmarkets, highlighting that markets do

respond to alling growth as lower uture profts cause asset valuations to all. So how does one make

sense o the relationship between real GDP and stockmarket perormance to ensure portolios can be

weighted accordingly to take advantage o this relative perormance?

Given the relationship between real GDP growth and equity market perormance is not consistent,

other approaches to understanding equity market perormance may well prove ar more productive.An innovative and perhaps more insightul way o trying to understand relative equity perormance is

again to turn to Wicksell, specifcally his monetary ramework. As detailed previously (Aubrey, Profting

rom Monetary Policy, Inostream Q2 2011), Wicksell argued that monetary imbalances can be analysed

by assessing the dierence between the return on capital and the cost o capital, or in Wicksells

terminology the natural rate and money rate o interest. According to the ramework, any such

positive monetary imbalances increase profts. Moreover, it is the rate o growth o excess profts that

largely drives stockmarket behaviour, with excess profts being defned as the dierence between the

two rates o interest, otherwise known as the Wicksellian Dierential.

One actor to note in using a Wicksellian approach is that it is constructed rom a micro perspective,

whereas current monetary theory ocuses on the general price level and an equilibrium rate o real

GDP growth. Hayek pointed out in the late 1920s that ocusing on maintaining price stability and an

equilibrium rate o growth generates alse signals, causing investors to lose money. The Wall Street

Crash o 1929 as well as the recent fnancial crisis demonstrate that Hayeks insight has been proved

correct and potentially highly proftable or those who decided not to ollow current monetary theory

and its ocus on the general price level.

Charts 2 and 3 demonstrate the closeness o the relationship between excess profts and equity market

valuations, with a rise in excess profts (the Wicksellian dierential) in both Canada and Australia being

associated with rising stockmarkets. When excess profts all, equity valuations all, and when the

excess proft is negative, stockmarket perormance is muted. Moreover, Wicksells investment approach

also highlights equity market bubbles when asset values increase while excess profts are alling. The

reasons or this include the irrational exuberance o market participants, but also the act that globalstockmarkets are highly correlated. Hence moves in larger stockmarkets have some impact on asset

valuations in smaller markets such as Canada and Australia.

Chart 1:

Real GDP growth

Canada and Australia

vs Canada, Australia,

USA relative equity

market perormance


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Chart 2:

Canadian Wicksellian

dierential vs stockmarket

perormance

Chart 3:

Australian Wicksellian

dierential vs stockmarket

perormance

Its all in the leverage

Although Wicksells ramework provides a robust benchmark or equity valuations, given the datasets

are ex post they are not particularly helpul or investors trying to use this ramework to invest through

the business cycle and to beat relative benchmarks. The task at hand is thereore to attempt to

ascertain what might be driving an increased return on capital at the frm level assuming the cost o

capital remains constant.

Negative excess proft

growth implies muted

stockmarket perormance

Equity market bubbles

highlighted as rate o proft

alls but asset values rise


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A growth in demand due to increased consumption has the largest impact on increasing the rate o

return, assuming that the production o an incremental unit o output requires less than an equivalent

input. Hence, consumer behaviour plays a signifcant role in driving excess profts. In most developed

economies, consumption accounts or well over hal o output (Canada is 57% and Australia is 54%).

However, or consumption to maintain its level o growth, savings need to decrease and/or consumers

need to leverage up. Increasing consumer leverage requires the banking sector to provide consumers

with access to credit, which in turn raises leverage in the banking sector. As the recent fnancial crisis

demonstrated, ever-increasing leverage within the banking sector is not sustainable in the long run.

At some stage, expectations o uture profts shit, with banks tightening their lending criteria and

consumers deciding not to increase their own levels o debt. This process can then reverse causingdeleveraging which o course impacts uture proft growth adversely.

Charts 4 and 5 demonstrate two points. First is the rather extraordinary act that during the period o

the Great Moderation, consumer leverage rose two thirds in Canada and two-old in Australia (right-

hand scales). Thus stockmarket perormance (let-hand scales) during this period ought to have been

unsurprising given the ability o consumers to increase aggregate demand. Second is the sensitivity o

stockmarkets to slowdowns in consumer leverage. Here it is worth pointing out that given the high degree

o correlation across stockmarkets, an increase in consumption may not necessarily stave o stockmarket

alls due to lower global aggregate demand, although it would imply a better relative perormance. Over

the last couple o years, consumer debt as a percentage o income in Australia and Canada has been

roughly on par at about 150%. However, since the onset o the fnancial crisis, Australias consumers havelargely been on strike, whereas Canadian consumers continue to leverage up.

Chart 4:

Canadian consumer

leverage vs stockmarket

perormance

Consumers continue to

leverage up


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Although consumption is the main driver o real GDP growth in both countries, investment has also

played a role in sustaining reasonable rates o real GDP growth. Investment in Canada accounts or 19%

o GDP and in Australia it is 27%, thus more than making up or its wavering consumers on the output

side. Moreover, the Wicksellian dierentials are reasonably high in both Canada and Australia at around

the 8% level, highlighting that investment is relatively productive compared to say Japan, which is under

the 2% mark. So given similar growth rates and higher investment rates in Australia, why has Canadas

stockmarket outperormed it? The key to this lies in understanding leverage rates across the economy.Leverage is good when it is sustainable and helps drive growth in asset values. However, it causes a all in

values when it becomes unsustainable. As a result, changes in leverage can impact expectations o uture

corporate profts substantially and in terms o leverage comparisons, Canada outperormed Australia on

nearly all counts.

Firstly, and most importantly, Canadian consumers remain on an upwardly leveraged course. Secondly,

the Canadian banking system is roughly a third less leveraged than Australias, highlighting that

consumers are less likely to see credit rationed, thus providing Canadian consumers with access to credit.

Thirdly, Canadas government and corporate sectors are more leveraged than Australias, which is good

or growth as it allows a aster rate o expansion, but just as importantly they are not so leveraged that

investors see the levels as unsustainable. These are all actors that would have been missed using real

GDP growth rates as a signal or equity market perormance.

Conclusion

Credit is central to Wicksells monetary analysis and is responsible or driving equity values up as well

as down. The dynamic o credit is largely excluded by current monetary thinking due to the act that

general equilibrium theory cannot model credit eectively. As a result, using crude real GDP measures

and the general price level may have resulted in investors overweighting Australian equities in portolios

as opposed to Canadian equities. In conclusion, Wicksells monetary theory oers investors the ability

to invest through the business cycle by providing an alternative ramework to the current ination/GDP

signals emanating rom central banks.

Chart 5:

Australian consumer

leverage vs stockmarket

perormance Consumers have stopped

leveraging up


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Further reading:

Aubrey, Profting rom Monetary Policy

Goldman Sachs Asset Management Linking GDP Growth and Equity Returns

Hayek, Monetary Theory o the Trade Cycle

MSCI Is there a link between GDP Growth and Equity Returns?

Wicksell, Interest and Prices

The views expressed in this article are the personal opinions o the author. The contents o this article are not

indicative o the opinions, commentaries or analyses o Fitchs rating analysts, and are thereore separate and

distinct rom rating analyst activity, actions and opinions. Nothing in this commentary is a recommendationto buy, sell or hold any security.

GDP Growth and Equity Returns Australia and Canada

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