Does good economics mean good equity return?

Conventional wisdom says that as the economy grows, companies will also grow which in turn will help equity indices to grow. Nevertheless, this wisdom need not hold true always and there are instances when it has failed. What this means is that despite the economy growing, the stock market returns may not be positive. The opposite also holds true, that is, equity returns might be phenomenal in a year when the actual economy didn’t do better. This is particularly applicable in shorter run when there is hardly any positive correlation between both. In a longer run, however, both economy and stock return move in a similar direction. Empirical evidence shows the negative correlation between economy growth and stock returns and this is true for every market whether it is emerging or developed market.

Even in the Indian context, we see a similar phenomenon. Last year when our economy grew by 6.5 per cent while the frontline equity indices gave a return of 28 per cent. While in year 2015 when the Indian economy grew by 7.11 per cent, equity indices gave return of negative 5 per cent. Going one step ahead, we ran a regression on equity returns and GDP growth since FY90. We found a negative slope which means that as economy grows, return may not grow in a same proportion and in fact degrows.

 One of the reasons for such relation is that many companies generate substantial part of their revenue from the international market, which may not account in domestic GDP growth. Other major reason being stock market is a leading economic indicator that discounts what is expected to happen. Hence, there is deviation in economic growth and returns generated by stock market. 

Therefore, at current juncture when the economy is witnessing a robust growth, the same cannot be translated into equity returns. Therefore, we expect equity returns to be moderate in current year. The mutual fund investors should also not expect the repetition of returns we see in year 2017 and adjust their expectation accordingly.