Healthy Equity Markets Boost Economic Growth

Is it a surprise that all of the countries with sizable stock markets are also wealthy economies? Or do stock markets make economies better? 

Intuitively, efficient financial markets should help companies finance growth, which, in turn, makes the economy bigger. A recent paper from the World Federation of Exchanges (WFE), which builds upon an extensive body of research in this area, seems to confirm it.

More developed financial markets see higher market caps and GDP

If we look at the data, we see that wealthy countries tend to have larger stock markets – even after adjusting for population sizes (we look at gross domestic product (GDP)/head and market cap/head), which allows us to compare large and small countries side-by-side.

Although, the opposite seems to occur for low-income countries (green circles).

Chart 1: Countries with bigger equity markets have bigger economies

High-income countries have strong institutions and retail participation

So, what do high-income economies do differently?

For one thing, it seems from other data (below) that investors need to be willing to invest their capital. They need to have trust in the institutions and regulatory bodies of their country. 

In the chart below, we see that high-income economies (blue bars) have consistently higher “Rule of Law” scores, as measured by the World Justice Project, than low- and middle-income economies (green bars).

Chart 2: Strong Rule of Law is effectively a prerequisite for high-income economies

Similarly, they need financial markets with appropriate infrastructure in place. 

We rank countries’ financial markets development as measured by the International Monetary Funds Financial Markets Index, which takes into account the “depth, access and efficiency” of each country’s financial markets. 

Countries with higher income levels tend to have more developed financial markets, but several (mostly) small European countries buck the overall trend.

Chart 3: Higher-income countries tend to have better developed financial markets

As we’ve also shown in the past, high-income countries like the U.S., Sweden and Australia, have the highest levels of household investment in equities.

It would seem from the data that strong Rule of Law and highly developed financial markets provide an environment that attracts capital.

Chart 4: Investor participation may foster positive feedback loop from equity markets to GDP

And research from Goldman Sachs shows that countries with higher shares of domestic equity ownership also tend to have higher valuations. 

Chart 5: Higher domestic equity ownership is correlated with higher equity valuations

That’s good for companies since it reduces their cost of capital, and it incentivizes more companies to go public.

All of these factors combined help to foster this positive feedback loop between equity markets and GDP.

Equity markets drive economic growth through multiple channels

We already know that countries with relatively bigger equity markets tend to be richer — and we know that richer countries tend to have strong institutions and active retail participation in equity markets.

But how do equity markets influence economic growth?

In their recent paper, the WFE show there are multiple ways:

1. Efficient allocation and mobilization of capital. When companies go public, it gives them money to invest, expand and innovate, ultimately driving job gains and economic growth. For investors, they look to invest in the most promising companies, supporting the companies with the best chance to grow and impact economic growth.
2. Liquidity channel. As markets become more liquid, they attract more investors, increasing the pool of capital, and with more money to invest, that can boost economic growth.
3. Information channel. Since markets price all available information, they provide information to investors and creditors, which makes it easier to monitor companies and make more efficient allocation decisions.
4. Diversification. Stock markets help investors manage risk via diversification, spreading investments between low-risk, low-reward companies and high-risk, high-reward companies – another way to more efficiently allocate capital, which results in higher economic growth.
5. Wealth effect. When asset prices rise (stocks, houses, etc.), it increases the owner’s wealth, giving them more confidence about their financial situation and inducing them to spend more – boosting the economy.

We’ve seen this wealth effect in play over the last 35 years. If you’ve invested in US S&P 500 stocks, you’ve seen them gain over 3600% since 1990 (chart below, orange line). That’s over 10x the return for housing (purple line), which is up over 300%, and much better than holding bonds (green line). 

Chart 6: Stock returns are 10x home price appreciation in the last 35 years

So, while stocks can be more volatile in the short run, they outperform in the long run, which is why they’re a foundational element of wealth creation. And those investments help companies expand the economy, while their returns fund consumer spending.

Equity markets drive economic growth in the short and long run

So, how does the WFE paper prove that growing equity markets result in stronger GDP growth?

They look across 37 countries we also looked at above, over 20 years. They track how real GDP and the equity market capitalization ratio – the size of the equity market relative to the size of the economy – interact. 

They find that in the short run: 

• High-income countries: There is a positive feedback loop between market cap ratio and economic growth, where growth in one causes growth in the other.
• Low- and middle-income countries: The relationship goes one way, where increasing market cap ratios lead to higher economic growth.

The one-way relationship for lower-income countries seems to infer that the stock is playing “a foundational role in economic development,” while a lack of investor participation might limit the transmission from economic growth back to market cap.

Still, in the short run, the effect of increasing market cap ratios on low- and middle-income economies is greater than for high-income economies. In fact, low- and middle-income economies see roughly triple the boost to GDP growth (chart below, green bar) that high-income economies get (blue bar) from a positive “shock” to the market cap ratio.

Chart 7: Positive shocks to market caps boost GDP, especially for low- and middle-income countries

In the long run, the relationship is one way for all countries, with increases in the market cap ratio boosting economic growth. This time, though, the effect is larger for high-income countries, perhaps because, as research suggests, “firms with access to more developed stock markets grow faster,” contributing more to economic growth.

So, for all countries, they find that a 10% increase in the market cap ratio leads to a 0.028% increase in long-run economic growth, while for high-income countries alone, it leads to a 0.045% increase in long-run real GDP growth.

Although this might sound small, it adds up over time. Take the U.S. economy for example. If the U.S. market cap ratio suddenly increased 10% in early 2000, the economy would be 1.1%, or $330 billion, larger today (roughly the GDP of Finland). That’s just from boosting the U.S.’s trend growth rate for real GDP over the last 25 years from 2.14% to 2.19%.

And this relationship isn’t merely correlation. The paper uses multiple econometric methods to prove the one-way causal relationship.  They do this by showing, statistically, that economic growth is dependent on the market cap ratio. In short, GDP is improved by growing the market cap ratio.

Countries should pursue improving equity markets to boost economic growth

Intuitively, it seems important to encourage capital formation.

This recent WFE paper proves it’s a good idea. No matter where a country falls on the income spectrum, promoting healthy equity markets is an important way to support their economy, as well as the financial security of their investors.