Ongoing talk of the risk of recessions is prompting questions about the strength of the relationship between economic growth and corporate earnings.
Corporate earnings are one of the key drivers of equity returns. So, it is no surprise that investors are keenly watching the health of domestic economies and their potential impact on market earnings and return prospects.
When an economy is performing well, consumers often spend more and business activity increases. As a result, corporate profit margins improve, leading to higher earnings growth. Conversely, during recessions when demand is weak, earnings growth typically turns negative.
Chart 1 shows that there is a positive relationship between EPS (earnings per share) growth and real GDP growth in the US over the last 50 years.
Such a clear link is unsurprising for an economy such as the US which is so dependent on domestic activity. But in other countries such as Germany, earnings growth is more closely tied to global growth due to a heavy reliance on exports and high exposure to overseas revenues.
The differences between GDP and earnings growth
The strength of the relationship between EPS and GDP growth is not perfect, and there are several factors contributing to the divergence.
Firstly, the stock market and corporate earnings may not be representative of the economy due to the sector composition. For example, European markets are smaller and less representative of domestic activity than the US stock market.
Secondly, EPS growth is a widely used measure in the market as it allows for easy comparison across different companies and shows the amount of profit a company generates per share. But there are limitations with the EPS metric.
Companies that need to raise capital can issue more shares which dilutes EPS. This dilution impact is more relevant to emerging markets (EMs).
For instance, access to conventional financing options, such as bank loans, may be more limited in EM countries. At the same time, the regulatory environment in EMs may make it easier for companies to issue new shares.
Thirdly, the revenues and earnings generated by the companies listed on the stock market may be driven by overseas growth or revenues, rather than the domestic economy, which will be the focus in the next section.
Importance of the global economy and trading partners
In some cases, the performance of the global economy and a country's main trading partners can have a greater impact on its corporate earnings than domestic growth.
Chart 2 shows that exports account for a higher share of GDP in the Asian economies, such as Hong Kong, Singapore, Taiwan, and South Korea. In comparison, the economies of the US, Brazil, and Japan are more domestic in nature.
It is worth highlighting that both Hong Kong and Singapore’s exports are greater than GDP as they are major re-exporters of goods and services.
At the same time, the export exposure to key trading partners matters. For Canada and Mexico, the US is a main trading partner as a sizeable portion of their total exports to the world, over 70%, is directed towards the US market (table 1). Moreover, a significant portion of the exports from the UK and Germany is directed towards Europe.
Some equity markets have greater exposure to overseas revenues…
We can also examine the proportion of revenue companies generate overseas to understand the domestic orientation of an equity market and its earnings.
Chart 3 shows that the companies in countries such as China and Brazil receive most of their revenues from domestic sources. In comparison, the UK and German stock markets have more multinational companies which generate the majority of their revenues overseas.
Overall, an equity market with lower exposure to foreign revenues is more likely to have a stronger relationship between corporate earnings and domestic growth.
…and rewiring of the global economy will have an impact
With the re-wiring of globalisation, some countries - particularly in the emerging world - are likely to be the key beneficiaries of changes in supply chains.
In the case of the US, the economy could benefit from reshoring where globalisation trends reverse because of what we are calling the “3D Reset”, with deglobalisation, demographic and decarbonisation trends set to become important drivers of economic activity over the medium term.
For other countries, these changes might increase the importance of the overseas activities and the profits being repatriated, which may not be reflected in the domestic GDP.
Domestic growth matters more to earnings in some countries
Clearly, some economies are more domestic than others. Table 2 shows the simple correlations between domestic and global GDP with EPS growth over the last decade. It is important to note that the correlations may vary depending on the frequency of the data and the time horizon under consideration, which is a limitation of this analysis.
That said, we find that the corporate earnings of countries such as China, US, and Japan, have stronger ties with domestic rather than global growth as their GDP has low exposure to exports.
In the case of China, the relationship between corporate earnings and domestic GDP growth is modest compared to other markets. But the link between Chinese earnings is even weaker with global economic activity, particularly when less than 15% of the equity market’s revenue is from overseas.
In comparison, Singapore, Germany, and UK have the weakest correlations between EPS growth and domestic growth. This is because the economic activity of these countries has stronger ties to global trade.
For Germany, corporate earnings are more closely correlated to global growth and the equity market receives 80% of revenues from overseas.
Meanwhile, the corporate earnings of Canada, Mexico and US have high correlations with global growth. This is likely due to the significant contribution of US GDP to global GDP and the US being a key trading partner of Canada and Mexico.
Which parts of the market are more sensitive to domestic growth
So far, our analysis has focused on the relationship between the overall market's earnings growth and GDP growth. But certain equity sectors have stronger connections to the domestic economy. The companies in these sectors tend to receive more of their revenues from domestic rather than overseas sources.
In the US, sectors that generate more overseas revenues, such as technology, communication services, and consumer staples, tend to have weaker correlations between the EPS growth of these sectors and GDP growth (table 3).
In contrast, sectors that are more domestically focused, such as real estate, financials, and industrials, typically have more positive correlations between earnings ands GDP growth.
Even though the technology sector has a large market capitalisation in the US market and generates most of its revenue overseas, US earnings still have a strong relationship with the overall economy.
This is primarily due to the composition of the equity index, which includes a substantial number of sectors that are more domestically oriented.
Across the different markets, economic growth does matter to corporate earnings. But the strength of the relationship is not perfect, and they do diverge.
In certain countries, such as Germany, earnings growth has stronger links to global growth due to a heavy reliance on exports and high exposure to overseas revenues. So, a slowdown in global growth is likely to have a greater impact on corporate earnings than a recession in the domestic economy.
In comparison, countries like the US, where corporate earnings rely more heavily on domestic activity, are expected to be more resilient in the face of a global economic slowdown.
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