Why markets don’t always mirror the economy

By Lilian Chovin, Head of Asset Allocation, Coutts

• Economies and equity markets overlap but are fundamentally different – driven in varying ways by key factors such as technology, sectors and geographies.
• At Coutts, our approach reflects this distinction, blending long-term economic analysis with current earnings trends regionally to help us position our portfolios and funds.
• This analysis has led to our recent decision to reduce our US equity exposure in favour of emerging markets, where we see more attractive ways to access artificial intelligence opportunities.

Economic data plays a central role in how investors think about markets. Growth, inflation and monetary policy help frame expectations for corporate performance and asset prices.

Yet one of the most commonly used indicators — gross domestic product (GDP) growth, or economic growth — can be an incomplete, and at times misleading, guide to equity market returns.

At first glance it would seem logical to assume that strong GDP growth would translate directly into strong equity returns. A growing economy suggests rising business activity, expanding incomes and increasing demand from consumers.

But equity markets do not represent the economy as a whole. They are collections of specific, listed companies, and their performance is driven by distinct factors: earnings growth, valuation changes, sector composition and exposure to global, rather than purely domestic, demand.

GDP growth, by contrast, focuses squarely on domestic economic output, capturing the total value of goods and services produced within a country. This makes it a useful indicator of economic health, but it does not directly reflect the profitability or valuation of the companies listed on its equity markets.

Spotting the difference

This disconnect becomes clearer when we consider how equity returns are generated. Over time, returns can be broken down into three components: dividends, growth in earnings-per-share (EPS), and changes in valuation multiples (a measure of how much investors are willing to pay for those earnings).

GDP growth does not map neatly onto any of these. While a stronger domestic economy can support profits earned within a country, it may not impact overseas earnings, and does not necessarily determine how much investors value those domestic profits. This means strong GDP does not automatically translate into strong equity returns.

International comparisons illustrate this disconnect well. China has delivered strong nominal GDP growth – around 11–12% per year since the early 1990s – yet its main equity benchmark, the Shanghai Composite, has only returned about 6% annually over that period.

By contrast, the US has seen slower GDP growth – roughly 4–5% per year – but stronger equity performance, with the S&P 500 returning close to 10–11% annually.

The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term needs. This article should not be taken as advice.

Economies and company earnings can also diverge

Even the relationship between GDP and corporate earnings is not completely stable.

In theory, stronger growth should support higher company revenues and profits. In practice, while GDP and earnings-per-share growth are indeed positively related over time, that relationship can be unstable. There are even rare occasions when GDP continues to grow as earnings weaken. 

There are many reasons for this, including the following:

• Profit margins can be squeezed by rising wages or input costs.
• Currency movements can affect overseas earnings.
• Commodity price swings can dominate profits in resource-heavy markets.
• Company activity such as leverage, share issuance and buybacks can create a gap between profits and earnings-per-share.

A more forward-looking, global market

Periods of technological change are particularly good illustrations of the divergence between economies and markets. The current wave of investment in artificial intelligence (AI) is already reflected in equity markets, with investors pricing-in expected gains in productivity, margins and scalability.

At the company level, AI can support profitability and operational efficiency relatively quickly. But at the macro level, these effects tend to appear more gradually, particularly where investment is directed towards imported technologies or intangible assets.

At the same time, equity gains do not come from the whole economy, but subsets of it. Equity indices tend to be concentrated in specific sectors that are highly scalable, profitable and globally competitive — such as technology, communication services, financials and healthcare.

The contrast between how sectors contribute to equity markets and economies can be significant. In the US, information technology represents around 35% of the S&P 500 but only 6% of GDP, while sectors such as industrials and real estate tend to contribute much more to economies than markets. 

The distinction between economies and markets is further reinforced by the global nature of corporate earnings. Companies generate revenues across regions, often with only limited connection to their home market. In the UK, for example, more than 75% of FTSE 100 revenues are generated overseas. Swiss equities are heavily exposed to global healthcare and consumer demand, while Taiwan and Korea are closely tied to the global semiconductor cycle.

Our approach: a focus on earnings and preference for emerging markets

Our investment approach takes all of this into account. We begin with a top-down view of the economic cycle to understand inflection points in growth, the direction of policy, and the broader market backdrop. This frames the opportunities available – but is only the starting point.

From there, we focus on identifying where expected earnings growth is strongest, and where that improvement is recognised in prices. Strong earnings alone are not enough.

Framed this way, the key question is not which economies are growing fastest, but where earnings and price momentum reinforce each other.

At present, this leads us to the AI theme – a structural force that is also already feeding into corporate earnings. But not all exposures are equal. While both the US and emerging markets (EM) are beneficiaries, they participate in different ways.

The US is primarily exposed to AI demand, particularly through hyperscalers and their significant capital expenditure programmes. This has supported strong price performance, but the link to actual, near-term earnings is becoming less clear. By contrast, EM – particularly in Asia – are more exposed to the supply side of AI, including semiconductors, memory and advanced hardware manufacturing. These areas are seeing more tangible earnings momentum that is also reflected in prices.

This is why we recently reduced our exposure to US equities in favour of EM. The former’s economy may be in robust shape, but the latter is demonstrating stronger earnings momentum, improving price trends, and less demanding valuations.

This change is just one example of how, in our view, a keen understanding of the differences between economies and markets could help investors navigate an increasingly complex global landscape. 

The above article has been written and published by Coutts Crown Dependencies investment provider, Coutts.