In my last article published in China Daily on March 22, we explored the different approaches to investing in emerging markets. This time, let's explore one of the ways of analyzing possible market returns from investing in emerging markets equities.

The traditional linkage between nominal GDP growth and stock market returns is usually thought to be via earnings. In fact, we find that there is just a 24 percent correlation between GDP growth and earnings growth in emerging markets. In part, this may be because the stock market does not represent the balance of the economy. In addition, at different times investors are prepared to pay different amounts for the same earnings stream as interest rates and the equity risk premium fluctuate. In other words, valuation matters.

Let's take year-on-year real GDP and year-on-year real local market returns for our analysis. In our calculations of historic data from a basket of emerging markets, we found a small positive relation between the two. When we tested the numbers on whether GDP growth is related to market growth in the following year, the result indicated that GDP growth is a poor indicator. However, when we switched the calculation around, we realized that there is a strong relationship between stock market performance and the following year's GDP growth. This means, if GDP growth is expected to do well next year, emerging stock markets will do well this year.

However, we are also aware that a number of countries that have "emerged" over recent years have experienced strong GDP and market growth. This is usually associated with periods of intensive capital build out.

For example, during the 1980s, when the Korean economy had an annualized growth of almost 10 percent, markets grew at 18 percent per annum. We see a similar pattern in the late 1970s in Taiwan with annualized GDP growth of around 8 percent and market growth of 9 percent per annum. A further period of strong growth in the 1980s saw growth around the 8 percent level coinciding with a bubble in equities and over 40 percent annualized growth.

So, can we test whether high persistent growth is associated with high market returns? The best way to test this is simply to look at longer term data. We do not want to use too long a period, otherwise we will move too far away from a sensible investment horizon (i.e., beyond any reasonable hope that predictions can be made). Using a data set across our basket of emerging countries of a five-year annualized return, we found that the instances of very high market returns occur only with high GDP growth.

If growth is not very high, the chances of getting very high market returns are quite small. So, history suggests that five years of strong GDP growth is much more likely to result in five years of strong returns and much less likely to result in flat or negative returns.

In conclusion, we found that strong GDP growth in any one year is generally reflected in strong stock market returns in the preceding year. When GDP growth is consistently strong (the five year compound rate stays high), stock markets do relatively better. Lastly, the chance of very high market returns is significantly enhanced when GDP growth is consistently strong.

Given current positive economic growth expectation for many emerging markets, this might well result in attractive investment returns in the year to come.

Lieven Debruyne is chief executive officer of Schroders Hong Kong. The opinions expressed are entirely his own.

(HK Edition 05/08/2010 page3)