FEATURE

A WICKSELLIAN EXPLANATION OF WHY CANADAS STOCKMARKET HAS OUTPERFORMED AUSTRALIAS

By Thomas Aubrey, Managing Director, Fitch Solutions The debate as to whether real GDP growth is a good indicator of equity market performance remains unresolved. Some market participants argue that there is a strong relationship between real GDP growth and earnings growth, hence higher equity prices. Others argue that given there is little correlation between the two figures over longer time periods, this cannot be the case. One issue in using real GDP growth signals as a barometer for equity market performance is that they are a product of current monetary economic theory and, given recent events, ought to be treated with greater scepticism by investors. At a very simplistic level, the current theory states that if output is able to grow without inflation then this generates higher-than-expected profits, in turn sending up equity prices. Unfortunately, during the period of the Great Moderation this growth took place at the expense of increasing leverage and hence was not sustainable, leading to a crash in equity prices and investors losing money. Indeed, despite stockmarket rises from March 2009, key equity benchmarks are still 15% down on where they were at the onset of the financial crisis. Another potentially more fruitful approach in trying to understand the dynamic of equity returns is to use Knut Wicksells monetary theory, which is based on the notion that credit drives capital values (equity). This article uses data from Australia and Canada to test Wicksells idea given both countries have strong growth rates but differing equity performance. It highlights that Canadas stockmarket has largely outperformed its Australian counterpart over the last five years due to the difference in leverage ratios across the respective economies. Canada and Australia: a tale of two countries Two countries that have escaped the worst of the crisis with reasonably robust real GDP growth rates are Canada and Australia. As a result, one might have expected equity markets in Australia and Canada to have outperformed their peers. Unfortunately, the data reveals that the relationship between real GDP growth and stockmarket performance is not consistent. Chart 1 shows that over the last five years, Australias real GDP growth rate has outperformed Canadas (left-hand axis), but its relative stockmarket performance has been lacklustre. Equity markets in Canada as well as the USA have both significantly outperformed Australia in the last five years (right-hand axis). However, as real GDP

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growth fell in 2008 across both countries, so did their stockmarkets, highlighting that markets do respond to falling growth as lower future profits cause asset valuations to fall. So how does one make sense of the relationship between real GDP and stockmarket performance to ensure portfolios can be weighted accordingly to take advantage of this relative performance?
Chart 1: Real GDP growth Canada and Australia vs Canada, Australia, USA relative equity market performance

Given the relationship between real GDP growth and equity market performance is not consistent, other approaches to understanding equity market performance may well prove far more productive. An innovative and perhaps more insightful way of trying to understand relative equity performance is again to turn to Wicksell, specifically his monetary framework. As detailed previously (Aubrey, Profiting from Monetary Policy, Infostream Q2 2011), Wicksell argued that monetary imbalances can be analysed by assessing the difference between the return on capital and the cost of capital, or in Wicksells terminology the natural rate and money rate of interest. According to the framework, any such positive monetary imbalances increase profits. Moreover, it is the rate of growth of excess profits that largely drives stockmarket behaviour, with excess profits being defined as the difference between the two rates of interest, otherwise known as the Wicksellian Differential. One factor to note in using a Wicksellian approach is that it is constructed from a micro perspective, whereas current monetary theory focuses on the general price level and an equilibrium rate of real GDP growth. Hayek pointed out in the late 1920s that focusing on maintaining price stability and an equilibrium rate of growth generates false signals, causing investors to lose money. The Wall Street Crash of 1929 as well as the recent financial crisis demonstrate that Hayeks insight has been proved correct and potentially highly profitable for those who decided not to follow current monetary theory and its focus on the general price level. Charts 2 and 3 demonstrate the closeness of the relationship between excess profits and equity market valuations, with a rise in excess profits (the Wicksellian differential) in both Canada and Australia being associated with rising stockmarkets. When excess profits fall, equity valuations fall, and when the excess profit is negative, stockmarket performance is muted. Moreover, Wicksells investment approach also highlights equity market bubbles when asset values increase while excess profits are falling. The reasons for this include the irrational exuberance of market participants, but also the fact that global stockmarkets are highly correlated. Hence moves in larger stockmarkets have some impact on asset valuations in smaller markets such as Canada and Australia.

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Chart 2: Canadian Wicksellian differential vs stockmarket performance

Equity market bubbles highlighted as rate of profit falls but asset values rise Negative excess profit growth implies muted stockmarket performance

Chart 3: Australian Wicksellian differential vs stockmarket performance

Its all in the leverage Although Wicksells framework provides a robust benchmark for equity valuations, given the datasets are ex post they are not particularly helpful for investors trying to use this framework to invest through the business cycle and to beat relative benchmarks. The task at hand is therefore to attempt to ascertain what might be driving an increased return on capital at the firm level assuming the cost of capital remains constant.

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A growth in demand due to increased consumption has the largest impact on increasing the rate of return, assuming that the production of an incremental unit of output requires less than an equivalent input. Hence, consumer behaviour plays a significant role in driving excess profits. In most developed economies, consumption accounts for well over half of output (Canada is 57% and Australia is 54%). However, for consumption to maintain its level of growth, savings need to decrease and/or consumers need to leverage up. Increasing consumer leverage requires the banking sector to provide consumers with access to credit, which in turn raises leverage in the banking sector. As the recent financial crisis demonstrated, ever-increasing leverage within the banking sector is not sustainable in the long run. At some stage, expectations of future profits shift, with banks tightening their lending criteria and consumers deciding not to increase their own levels of debt. This process can then reverse causing deleveraging which of course impacts future profit growth adversely. Charts 4 and 5 demonstrate two points. First is the rather extraordinary fact that during the period of the Great Moderation, consumer leverage rose two thirds in Canada and two-fold in Australia (righthand scales). Thus stockmarket performance (left-hand scales) during this period ought to have been unsurprising given the ability of consumers to increase aggregate demand. Second is the sensitivity of stockmarkets to slowdowns in consumer leverage. Here it is worth pointing out that given the high degree of correlation across stockmarkets, an increase in consumption may not necessarily stave off stockmarket falls due to lower global aggregate demand, although it would imply a better relative performance. Over the last couple of years, consumer debt as a percentage of income in Australia and Canada has been roughly on par at about 150%. However, since the onset of the financial crisis, Australias consumers have largely been on strike, whereas Canadian consumers continue to leverage up.
Chart 4: Canadian consumer leverage vs stockmarket performance Consumers continue to leverage up

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Chart 5: Australian consumer leverage vs stockmarket performance

Consumers have stopped leveraging up

Although consumption is the main driver of real GDP growth in both countries, investment has also played a role in sustaining reasonable rates of real GDP growth. Investment in Canada accounts for 19% of GDP and in Australia it is 27%, thus more than making up for its wavering consumers on the output side. Moreover, the Wicksellian differentials are reasonably high in both Canada and Australia at around the 8% level, highlighting that investment is relatively productive compared to say Japan, which is under the 2% mark. So given similar growth rates and higher investment rates in Australia, why has Canadas stockmarket outperformed it? The key to this lies in understanding leverage rates across the economy. Leverage is good when it is sustainable and helps drive growth in asset values. However, it causes a fall in values when it becomes unsustainable. As a result, changes in leverage can impact expectations of future corporate profits substantially and in terms of leverage comparisons, Canada outperformed Australia on nearly all counts. Firstly, and most importantly, Canadian consumers remain on an upwardly leveraged course. Secondly, the Canadian banking system is roughly a third less leveraged than Australias, highlighting that consumers are less likely to see credit rationed, thus providing Canadian consumers with access to credit. Thirdly, Canadas government and corporate sectors are more leveraged than Australias, which is good for growth as it allows a faster rate of expansion, but just as importantly they are not so leveraged that investors see the levels as unsustainable. These are all factors that would have been missed using real GDP growth rates as a signal for equity market performance. Conclusion Credit is central to Wicksells monetary analysis and is responsible for driving equity values up as well as down. The dynamic of credit is largely excluded by current monetary thinking due to the fact that general equilibrium theory cannot model credit effectively. As a result, using crude real GDP measures and the general price level may have resulted in investors overweighting Australian equities in portfolios as opposed to Canadian equities. In conclusion, Wicksells monetary theory offers investors the ability to invest through the business cycle by providing an alternative framework to the current inflation/GDP signals emanating from central banks.

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Further reading: Aubrey, Profiting from Monetary Policy Goldman Sachs Asset Management Linking GDP Growth and Equity Returns Hayek, Monetary Theory of the Trade Cycle MSCI Is there a link between GDP Growth and Equity Returns? Wicksell, Interest and Prices The views expressed in this article are the personal opinions of the author. The contents of this article are not indicative of the opinions, commentaries or analyses of Fitchs rating analysts, and are therefore separate and distinct from rating analyst activity, actions and opinions. Nothing in this commentary is a recommendation to buy, sell or hold any security.

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