Don’t Invest in An Economic Boom – Fat Tail Daily

Investors presume that the fate of stocks and the economy are somehow linked. All you need to do is figure out which part of the world the next economic growth miracle will occur. And then plough your money into it.

How often have you heard pundits tell you about the great opportunity in the Indian or Vietnamese stock markets? But their justification is all about economic growth.

Just look at the size of the emerging middle-class…urbanisation will drive GDP for decades…the catch-up effect will boost the economy…don’t they all want fridges and air conditioners too?

With that sort of boom, the local stock market can only go up!

What if this isn’t just wrong, but the opposite is the case?

What if economic growth and stock market performance are actually inversely correlated?

That is, when the economy does well, stocks do badly.

And when the economy does badly, stocks do well.

It sounds absurd, I know. But the evidence is actually quite clear. As the market historian Russell Napier says in his lecture 21 Lessons From History, ‘GDP growth has no relation to future returns.’

Today, I’d like to claim there’s an inverse correlation. But first, what’s the evidence and explanation for the counterintuitive conclusion?

There are a lot of examples from history. But let’s take the most recent one.

The German stock market is booming
during a recession

Recently, the German stock market has been on an absolute tear. The DAX is up almost 40% since January!

Meanwhile, the German economy has been the laughingstock of the world. Two consecutive years of economic contraction – the longest period of economic stagnation since World War II.

Why the divergence? The reasons were explained in painfully great detail in a Deutsche Bank report sent to me by a journalist attending Davos at the time.

In short, the big German companies that dominate the German stock market index are global companies. They care about what’s going on in the international economy. Only a fifth of their sales are inside Germany itself.

This is true of most economies you might invest in. The companies that are large enough to feature in their index are too international to be much of a proxy for the local economy.

Secondly, a weaker exchange rate boosts such companies’ profits. For the Germans, a weaker euro means bigger profits in terms of euro.

Conveniently, the weaker the German economy, the weaker the euro and the better German companies’ foreign revenues appear on paper.

And so the German stocks go up during a recession…in terms of euro, at least.

That makes the stock market negatively correlated to the economy!

All this is why UK stocks soared after Brexit and why the stock markets of places like Venezuela, Zimbabwe and Weimar Germany soar. Not to mention Japan recently.

And that brings us to the real issue…

Exchange rates can drive returns

For the last few months, I’ve been warning Fat Tail Daily readers about the power of exchange rates to ruin their returns. And I’m going to do it again. Because the free lunch you’ve been eating will soon turn into a health problem.

For years now, any investment in overseas assets has performed remarkably well for Australian investors. Because the Aussie dollar slowly fell, their overseas stocks appeared to go up.

If that reverses, then the tailwind will become a headwind. A rising Aussie dollar will create a bar that returns in foreign assets have to rise above to leave you with net capital gains in terms of local currency.

But it’s worse than that. Because you can’t just invest locally to escape the exchange rate trap. Local companies that have revenue in foreign currency will see the value of those revenues fall in local terms as the Aussie dollar rises. That’s many of the companies in the ASX200.

Just as stocks perform well when the economy is performing poorly, so too vice versa. A booming economy pushes up the exchange rate, acting as a lid on stock market prices.

You might remember the two speed economy Australia experience during the resources boom. The economy was struggling. Yet local stocks did well.

But the Australian dollar eventually soaked up a lot of the gains, with the exchange surging to more than one to one with the US dollar.

Foreign investors in Australian companies benefited from the exchange rate moves while local investors missed out on the gains.

Don’t buy into GDP growth stories

There are four lessons to learn from all this.

You shouldn’t blindly buy stocks in countries that’ll experience an economic boom. The exchange rate could soak up the gains from the stock market and put a lid on the stocks there.

Second, what types of stocks you buy changes your exposure to the exchange rate issue. Some local Aussie companies would be just fine with the Australian dollar surging. Others would be undermined by it. You need to be able to tell the difference. And invest accordingly.

Third, the bar which your overseas investments need to jump over is going to be higher in the future than it was in the past. You may want to adjust your risk exposure to stocks that have the potential to deliver higher returns, even if the risk is also higher.

And last but not least, you can offset currency and GDP risk by investing in companies that have such a high risk profile that exchange rates and GDP growth are the least of your worries.

To find out more about opportunities like this, go here.

Regards,

Nick Hubble,
Editor, Strategic Intelligence Australia

P.S: PANIC STATIONS! — Please register if you haven’t already for our market warning bombshell on 27 March. You can do so here.

All advice is general advice and has not taken into account your personal circumstances.

Please seek independent financial advice regarding your own situation, or if in doubt about the suitability of an investment.