Why Potential Growth Matters to Investors
There's a limit to how much stuff you can produce. Put all workers and all machines together running at a normal rate, and you have potential GDP. Anything above this, and workers will demand overtime, prices will go up, and inflation will ensue.
Now from an investor's standpoint, the interesting question is how this relates to stock prices. Stock prices are based on corporate earnings, so those earnings are the key here.
Suppose that earnings as a share of total output continue to rise and rise. Since all output is paid to either capital or labor, what do you think would happen eventually?
Exactly!
Since production is split between capital (owners) and labor (workers), a higher and higher share of output going to capital would mean less and less for workers. Eventually they wouldn't want to do that anymore, and things would stop.
So really there should be some upper limit to the ratio of earnings to output (or in other words, earnings divided by GDP).
No, the capital owners would be in paradise. They wouldn't withdraw their capital.
No, not everyone. Consider who loses if more and more of output is going to capital owners.
Equity returns basically come down to dividends and capital gains; the two sources of return. The dividend yield is what it is, but capital gains are affected by any change in the P/E ratio, inflation (_i_), real economic growth (_g_), and any change in the number of shares outstanding.
$$ E(R_e) = dy + \Delta(P/E) + i + g + \Delta S$$
Suppose _g_ is high for a country. Assuming that this boosts investors' expectations, what would that cause to be higher at the same time?
Unlikely; the dividend yield has been fairly stable over time.
That wouldn't necessarily play into inflation. Consider equity investors' behavior when they see a nation's growth prospects to be quite positive.
Right.
The dividend yield is usually stable, but higher expected growth will lead to more investment and an expansion of the multiples.
Now, think about real interest rates. They are the benefit to savers waiting to consume. If potential GDP is growing quickly, these savers are going to expect higher future incomes. What do you think that means for real interest rates?
No, they should be higher, actually.
Excellent!
If people are expecting higher future income, then they will want to consume more. So convincing them to put off that consumption will be harder. So the real interest rate, used to lure them into just that, must be higher.
The idea of potential GDP is also related to debt markets. Higher growth means better credit overall. Lending isn't as risky when businesses are doing really well. The gap from actual to potential GDP also gives fixed income analysts some clue as to what the central bank may be planning. Along with monetary policy, some fiscal policy may follow from this gap as well, which also affects interest rates.
So yes, potential growth matters a great deal to investors of all types.
To summarize,
[[summary]]
Take a look at that last term, $$\Delta S$$. This is a dilution factor, essentially. What sounds more like higher returns for equity investors: share issuance or buybacks?
No, buybacks. This is considered an alternative to cash dividends, where the company uses excess cash to purchase shares from the open market, increasing the value of the remaining shares.
Of course. This is considered an alternative to cash dividends, where the company uses excess cash to purchase shares from the open market, increasing the value of the remaining shares.
Another piece of this dilution effect is called "relative dynamism," and it has to do with smaller companies that aren't publicly traded. If smaller companies do really well, what does that mean for stock market returns and economic growth?
No, strong performance of small business will help economic growth.
No, strong performance of small business won't help the returns of publicly traded stocks.
Yes!
The dilution effect can be expanded as net buybacks plus this dynamic relativism. Here's a sample of real equity returns, economic growth, net buybacks, and relative dynamism for a few countries:
| Country | Real equity return | Real GDP growth | Net Buybacks | Relative Dynamism |
|-----|-----|-----|-----|-----|
| Chile | 4.8% | 2.9% | 1.1% | 0.0% |
| Czechia | 6.3% | 2.2% | 6.0% | -11.7% |
| Egypt | 9.4% | 2.3% | 5.5% | -3.9% |
| Greece | -8.7% | 0.5% | -12.7% | 0.2% |
| Poland | 1.9% | 3.9% | -11.9% | 7.1% |
What appears to cause real equity returns to fall short of economic growth?
Not really.
Notice that "real equity returns falling short of economic growth" describes the last two countries on the list.
Not really.
Notice that "real equity returns falling short of economic growth" describes the last two countries on the list, where net buybacks were actually negative.
That's it.
If you want public equity returns to be higher, you'd want lots of buybacks and a smaller level of relative dynamism. This describes the first three countries perfectly. In the last two, this is reversed; net buybacks are negative while there is positive relative dynamism, and equity returns are lower than economic growth.
Workers would quit
Capital would be withdrawn
Everyone would become wealthier
$$dy$$
$$i$$
$$\Delta (P/E)$$
They should be lower
They should be higher
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Issuance
Buybacks
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They will be lower
They will be higher
They will diverge more
High net buybacks and relative dynamism
High net buybacks and low relative dynamism
Low net buybacks and high relative dynamism
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