Application of Economic Growth Trend Analysis to the Formulation of CMEs

The expected trend growth rate is an all-important element in developing capital market expectations. Its primary use is in developing expected returns for asset classes. In addition, it informs potential currency movements and government policy.

Critical considerations of economic trend growth rate include:

• Higher trend growth rates imply higher yields on government bonds.
• Discounted cash flow models incorporate the trend growth rate when forecasting returns.
• Higher trend growth rates may imply higher stock returns.
• A higher trend growth rate may result in a faster-growing economy, given that increased inflation is sustainable.

GDP Growth Decomposition

GDP can be thought of as a combination of two components:

1. Growth from labor.
2. Growth from labor productivity.

The first factor consists of potential labor force size growth and actual labor force participation. The second factor consists of growth from increasing capital inputs and growth in total factor productivity. Total factor productivity represents innovation and technological advancements and can be described as the overall dynamism of an economy. It is thought of as a leverage factor for capital inputs. Capital inputs involve any assets used to run a business, including computers, PP&E, inventory, etc. When growth from labor and labor productivity do not explain the GDP growth, the leftover is explained by total factor productivity (hence the term residual).

Asset Returns and Trend Growth Rate of GDP

Both theory and empirical evidence demonstrate that real default-free bond yields are mean-reverting and will move toward the real GDP trend growth rate. The following formula also demonstrates the importance of the long-term growth rate of GDP in determining aggregate equity market prices.

$$ \text{Price}=\text{GDP} \times \frac {\text{Earnings}}{\text{GDP}} \times \frac {\text{Price} }{ \text{Earnings} } $$

This equation ties out algebraically and omits ‘Price’, which is the general price for an entire market such as the S&P 500. The ‘Earnings’ part is also a general reference to the corporate earnings of the same market.

The second term, Earnings/GDP, relates to the amount of GDP that goes to firms, not private citizens. So, GDP is the available profits allocated to businesses and private citizens. The third term relates to the relative market valuation concerning its earnings. How expensive is the market at current valuations? How much must an investor pay in order to access $1.00 of the underlying earnings?

The second and third terms in the equation can influence markets in the short run, although they are essentially mean-reverting and follow a trend. GDP is the primary driver of aggregate stock market valuation over the long run.

In the long run, the economic growth rate is a significant variable. Even small differences in growth rates matter because of the power of compounding. Thus, even a few policy actions affecting the long-term growth rate, even by a small amount, will have a significant economic impact.

Question

Stanley Milner, CFA, is a financial analyst tasked with calculating equity values for country ZA2. Based on the following information, which factor can least likely be expected to increase the equity index in country ZA2?

1. Equity valuation multiples trend lower.GDP trend growth goes from 4.5% to 4.65%.
2. GDP trend growth goes from 4.5% to 4.65%.
3. Corporate earnings represent an increasingly more significant percentage of GDP.

Solution

The correct answer is A.

Higher P/E ratios (valuation multiples) imply a more expensive aggregate stock market.

B is incorrect:

According to the formula:

$$ \text{Price}=\text{GDP} \times \frac {\text{Earnings}}{\text{GDP}} \times \frac {\text{Price} }{ \text{Earnings} } $$

Increasing GDP would increase the price of potential earnings for corporations. This has the effect of increasing aggregate equity values.

C is incorrect. Corporate earnings represent an increasingly significant percentage of GDP and a potential move higher in aggregate stock valuations as corporations earn more than private government citizens.

Reading 1: Capital Market Expectations – Part 1 (Framework and Macro Considerations)

Los 1 (d) Discuss the application of economic growth trend analysis to the formulation of capital market expectations