Asset Allocation: Growth and Equities?

by Michael J. Howell12. December 2012 20:44
A recent FT blog contained academic wranglings concerning the 'fact' that faster economic growth is associated with lower equity returns! The professors are striving to find a paradox when really there is not one. Bonds (taking due account of inflation) correlate negatively with GDP growth and commodity prices (taking due account of resource sector productivity) correlate positively with GDP growth. These two asset markets seem to do what theory says. However, when equities are introduced, sometimes they correlate negatively with bonds and sometimes positively. It looks like equities are at fault. But we know that eps growth is strongly positively correlated to GDP growth, so the true culprit is equity valuation. Since P/Es cannot disappear to zero, this tells us that different valuation regimes must exist that include periods when valuations move oppositely to eps growth. Thus, sometimes equity valuations are pro-cyclical, e.g. right now, and sometimes they are anti-cyclical, e.g. 1980s and 1990s: two periods when they saw their highest correlation to bonds. What explains these regimes is a combination of inflation, the credit cycle and the starting valuation level. Moderate inflations, with strong credit growth, are typically when equity valuations are at their highest. The bottom line is that when economic activity picks up: equities will outperform. See latest research note: 'The Return of TAA'


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