Understanding how macro economic factors impact equity returns

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We all know that economics & stock market are correlated. Macro & Micro economics ultimately influence stock prices in the long run. In this article, we will attempt to explain the correlation between the two in a simple language. Understanding this is essential to every investor. Economic analysis is one of the pillars behind equity forecasting. It plays a key role in arriving at probable future returns from equities. For HNIs, who invest across the world, economic analysis helps them to shortlist countries with expected future returns. 

Future stock prices are largely governed by a company’s ability to generate more money from operations. For the sake of simplicity, we restrict ourselves to only two major factors from macro economics which can help us to predict future earning in a country. These are GDP & Inflation.

Factor 1: Annual GDP (Gross Domestic Product): Annual GDP is the monetary sum of all goods & services produced within the country during a year. If a country’s GDP is growing, it means that companies must be selling more products and thus generating more revenue which will help to push up stock prices. Currently India’s GDP stands at 7.1% for year 2016-2017, it was 8% in the previous year.

Factor 2: Annual Inflation: It is the rate at which the general price level of goods and services are rising every year. With inflation, product price also increases and helps to generate more revenue for the company which again helps increase stock prices. With inflation, there is increase in input cost for the company as well but usually it is passed through to the buyers.

The Formula: Below formula can be used for calculating expected returns from equities in a country. Unlike usual formula, this will not give an accurate number year on year but this is still be a reliable method. Even Warren Buffet uses GDP/Market cap ratio to gauge a country’s return potential which is based on similar lines.

Equity Return % = GDP Growth Rate % + Inflation Rate % +/- Buffer (4%)

Applicability of this formula: This formula takes into account only macro economic variables which are an aggregated sum of numbers from different sectors of a country. So this equation represents country’s equity market potential but it fails to deliver much value if you apply it for any specific sector or a company since all sectors/companies in a country will not grow at the same rate. Depending upon micro economic variables, some sectors/companies will grow faster and some will grow slower. Lastly, it’s management quality which will differentiate within a sector which company will perform above or below the sector growth rate.

Testing the formula: To test above formula, we plotted a graph by taking data for India’s GDP, Inflation & BSE sensex annual return from 1980 to 2016. Equity returns are very volatile so to smooth out graphs and make them understandable, we took rolling average for last 10 years. So for year 2016, we took average from 2016 till 2007. Similarly, for 2015, we took average from 2015 till 2006 and so on for other years. This makes sense since it takes time for macro economic factors to play out their effect on equities.

Senex Returns

Since these are rolling return so there are no negative entries because we never had 10 consecutive years of negative returns from sensex. As we can see the sensex return (white graph) is following the sum of GDP (red) & Inflation (blue) with some buffer. This buffer depends on the market mood which can be optimism or pessimism. Some analyst may term this buffer as “equity premium” as well. There are a few points to note regarding this analysis:

  1. It only represents average returns from large caps since Sensex represents only 30 large cap stocks, picture may be very different for small or mid caps.
  2. We have taken rolling average of 10 years to simply the viewpoint and graph. Actual returns per year are highly volatile and there is no way, we can establish any correlation in per year data, which means this can not be used for predicting next year’s return but we can use it to expect what next 10 year return will look like.

Take away from this research is that during bull run when market mood is upbeat, sensex returns are overshooting (year 1995) by a big margin with respect to sum of GDP & Inflation which means buffer is increased to as high as 17%. During bear phase, this buffer is getting depleted to almost zero or even in minus (year 2003). True to the popular belief that market occasionally goes into oversold or overbought zones.

What’s Next: Today in July 2018, Inflation is again rising while GDP numbers are almost flat. Ideally, future equity returns shall gradually start to pick up after a lag. Currently, equity returns are coming down because it is still adjusting itself for the previous cycle. In previous cycle, inflation was down and so were interest rates. Crude oil was cheap & Rupee was strong. Today is exactly opposite. So in nutshell, future is bright for equities. This may sound surprising but this is a good time for fresh investments.

This theory & equation are more applicable to large caps, the returns from small cap stocks may vary. There will be multibaggers within small cap space, it is just that finding them is difficult. Most of the multibagger stories in media are using past data & it may not repeat in future. In current environment, finding multibagger is becoming tricky day by day.

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