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THE Shanghai-Hong Kong Stock Connect， the system by which Hong Kong investors can buy China’s mainland shares and vice versa， has so far not lived up to certain public expressions of “great expectations” which surrounded its launch in November 2014. At that time some media commentators said this was the most important development in Asian shares for decades.
Such expectations did not materialize. When it came to the Connect’s practical operation， Reuters found， reviewing the situation one month after its starting date：“Under the scheme， the daily limit on investment bound for Shanghai is RMB 13 billion （US $2.1 billion） and for Hong Kong-bound investment it is RMB 10.5 billion. Typically， only a small portion of this has been used.”
Overall Reuters noted： “Demand has been subdued and the bulk of activity has come from short-term speculative investors. The authorities had hoped mutual and pension funds and private banks would form the bedrock of the Shanghai-Hong Kong Stock Connect. But early trade volumes in the program… were completely dominated by hedge funds and banks’ proprietary trading desk.”
At that time hope was expressed that this would rapidly change – instead of short-term hedge operators， companies buying shares expecting price and earnings gains –“long funds” – would become major players： “We expect more participation from the long-only funds in the coming months，” said Nick Ronalds， head of equities at Asia Securities Industry & Financial Markets Association.
This did not occur. The Asian Investor noted in January， under the self-explanatory headline “Long-only Firms in HK Shun Stock Connect”： “Only one in three is using the link with Shanghai two months after its launch.”
These failures could not be attributed to negative immediate trends in share markets on China’s mainland. The Shanghai Stock Exchange’s 53 percent rise in 2014 was the biggest in Asia.
Why， therefore， despite huge short-term rises in China’s share prices， were long-term investors， the type the mainland is interested in， not investing？ Instead the Connect was dominated by hedge funds and short- term operations – the financial factors of least interest to China， and which may even be damaging. Is this inexplicable， out of line with share market theory？
The answer is no. The result was predictable both from economic theory and other countries’ experience.“Disappointment” occurred only because of insufficient examination of the facts of share market performance –not carefully following the wise Chinese dictum “seeking truth from facts.” A complaint has sometimes been put forward in China， and surprise expressed， that it had the world’s most rapidly growing major economy but one of the world’s worst performing share markets – even after rises in 2014 the Shanghai Composite at the beginning of 2015 was 45 percent below its 2007 peak. But this surprise was due to a hidden but false assumption that there is a positive correlation between economic growth and share market returns， i.e. the faster an economy grows the better its share market performs.
In fact all international and historical experience shows the reverse – the faster an economy’s per capita GDP grows the lower its returns on shares. Furthermore， this finding is not of one but of every major study.
Taking the main studies of the relation between economic growth and returns on shares， Siegel’s standard work Stocks for the Long Run finds： “Real GDP growth is negatively correlated with stock market returns. That is， higher economic growth in individual [developed] countries is associated with lower returns to equity investors. Similarly， [regarding] the stock returns for the developing countries... there is a negative relation between the returns in individual countries and the growth rates of their GDP.”
Dimson， Marsh and Staunton’s Triumph of the Optimists found， regarding total real return on equities and GDP per capita growth： “Statistically， the correlation is-0.27 for 1900-2000 and -0.03 for 1951-2000.” Updating their study， for the Credit Suisse Global Investment Returns Yearbook， they concluded： “[Taking] the real equity returns of the 19 Yearbook countries over the period 1900–2009， from lowest to highest... shows that the supposed association between long-run real growth in GDP per capita and real equity returns is simply not there （the correlation is -0.23）.”
Regarding the correlation of GDP per capita growth and share price increases， Ritter’s Economic Growth and Equity Returns found： “My calculations for… 16 [developed] countries over the 1900-2002 period get a correlation of -0.37.”
Jain and Kranson’s survey The Myth of GDP and Stock Market Returns noted： “The data show clearly that， over long periods and when adjusted for inflation， stock market returns and GDP per capita growth are negatively correlated.”
In 2011， after an extensively review of data， the Goldman Sachs Group noted that the negative correlation between GDP per capita growth and share price growth extended to different groups of economies ranked by growth rate： “If one invested in the slowest growing quintile of countries during this hundred-year- plus period， the equity returns would have outperformed the fastest growing quintile by three percent a year… Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly five percent a year.” China， naturally， was no exception， Goldman Sachs noted： “China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns… China’s economy has outgrown that of the U.S. by about eight percent a year since the end of 1992… Its equity market， however， has lagged that of the U.S. by about eight percent a year. Over the last 15 years， earnings per share growth in China has been a negative 0.9 percent while that of the S&P 500 companies has been 5.4 percent a year... Since the peak of U.S. and Chinese equities in October 2007， China has outgrown the U.S. by an estimated 10 percent a year， but Chinese equities have lagged the U.S. by 2.7 percent a year.”
Goldman Sachs concluded： “Whether it is one year， three years or 18 years， economic growth has not translated into better investment returns in China… The evidence shows that faster economic growth rates do not result in higher equity returns. In fact， if faster growth is priced into the equity markets， the equity markets are most likely going to lag those of slower growth economies.”
Why rapidly growing economies have badly performing shares is understood. It is because company resources are invested rather than distributed as dividends– therefore high dividends are positively correlated with high returns on shares， and rapid economic growth is negatively correlated. But for present purposes all that need be noted are the firmly established facts.
These are， of course， long-term correlations. They do not preclude purely short-term movements which contradict these trends， such as， for example， recent sharp gains in Shanghai. Furthermore， hedge funds and similar operators can make profits even in falling markets， and are particularly attracted by very sharp short-term movements such as in Shanghai last year.
Therefore， from share market theory， it would be expected that China’s share market would be profitable for short-term hedging operations， but it would be unsuitable for long-term investors seeking positive rewards. This is exactly how the Connect has functioned. It is therefore not in contradiction with but in line with share market theory.
The consequences are clear. China can have strong economic growth， or it can have a strongly performing share market. It cannot have both. Only a severe economic slowdown would lead to China having above average returns on shares – making it attractive for foreign investors. It is clear whether strong economic development or a high share market is most important for China. International comparisons show that 86 percent of growth in consumption， an indispensable basis of living standards， is accounted for by GDP growth. As China’s living standard is less than 20 percent of the U.S.， it is strong economic growth， not a strongly performing stock exchange， that is important for China’s population.
“Facts are stubborn things，” as the saying goes. Attempts to ignore the realities of stock market performance naturally do not alter the performance of these markets – as realities are much more powerful than inaccurate ideas.
Fortunately the sums traded under the ShanghaiHong Kong Stock Connect are too small to significantly affect China’s economy in either direction. But more damaging initiatives could result from wrong analyses of the relation between economic growth and share market returns. The Shanghai-Hong Kong Stock Connect is therefore of wider significance in showing the importance for China’s economic policy of understanding the real factual relation between economic growth and share market performance.
Such expectations did not materialize. When it came to the Connect’s practical operation， Reuters found， reviewing the situation one month after its starting date：“Under the scheme， the daily limit on investment bound for Shanghai is RMB 13 billion （US $2.1 billion） and for Hong Kong-bound investment it is RMB 10.5 billion. Typically， only a small portion of this has been used.”
Overall Reuters noted： “Demand has been subdued and the bulk of activity has come from short-term speculative investors. The authorities had hoped mutual and pension funds and private banks would form the bedrock of the Shanghai-Hong Kong Stock Connect. But early trade volumes in the program… were completely dominated by hedge funds and banks’ proprietary trading desk.”
At that time hope was expressed that this would rapidly change – instead of short-term hedge operators， companies buying shares expecting price and earnings gains –“long funds” – would become major players： “We expect more participation from the long-only funds in the coming months，” said Nick Ronalds， head of equities at Asia Securities Industry & Financial Markets Association.
This did not occur. The Asian Investor noted in January， under the self-explanatory headline “Long-only Firms in HK Shun Stock Connect”： “Only one in three is using the link with Shanghai two months after its launch.”
These failures could not be attributed to negative immediate trends in share markets on China’s mainland. The Shanghai Stock Exchange’s 53 percent rise in 2014 was the biggest in Asia.
Why， therefore， despite huge short-term rises in China’s share prices， were long-term investors， the type the mainland is interested in， not investing？ Instead the Connect was dominated by hedge funds and short- term operations – the financial factors of least interest to China， and which may even be damaging. Is this inexplicable， out of line with share market theory？
The answer is no. The result was predictable both from economic theory and other countries’ experience.“Disappointment” occurred only because of insufficient examination of the facts of share market performance –not carefully following the wise Chinese dictum “seeking truth from facts.” A complaint has sometimes been put forward in China， and surprise expressed， that it had the world’s most rapidly growing major economy but one of the world’s worst performing share markets – even after rises in 2014 the Shanghai Composite at the beginning of 2015 was 45 percent below its 2007 peak. But this surprise was due to a hidden but false assumption that there is a positive correlation between economic growth and share market returns， i.e. the faster an economy grows the better its share market performs.
In fact all international and historical experience shows the reverse – the faster an economy’s per capita GDP grows the lower its returns on shares. Furthermore， this finding is not of one but of every major study.
Taking the main studies of the relation between economic growth and returns on shares， Siegel’s standard work Stocks for the Long Run finds： “Real GDP growth is negatively correlated with stock market returns. That is， higher economic growth in individual [developed] countries is associated with lower returns to equity investors. Similarly， [regarding] the stock returns for the developing countries... there is a negative relation between the returns in individual countries and the growth rates of their GDP.”
Dimson， Marsh and Staunton’s Triumph of the Optimists found， regarding total real return on equities and GDP per capita growth： “Statistically， the correlation is-0.27 for 1900-2000 and -0.03 for 1951-2000.” Updating their study， for the Credit Suisse Global Investment Returns Yearbook， they concluded： “[Taking] the real equity returns of the 19 Yearbook countries over the period 1900–2009， from lowest to highest... shows that the supposed association between long-run real growth in GDP per capita and real equity returns is simply not there （the correlation is -0.23）.”
Regarding the correlation of GDP per capita growth and share price increases， Ritter’s Economic Growth and Equity Returns found： “My calculations for… 16 [developed] countries over the 1900-2002 period get a correlation of -0.37.”
Jain and Kranson’s survey The Myth of GDP and Stock Market Returns noted： “The data show clearly that， over long periods and when adjusted for inflation， stock market returns and GDP per capita growth are negatively correlated.”
In 2011， after an extensively review of data， the Goldman Sachs Group noted that the negative correlation between GDP per capita growth and share price growth extended to different groups of economies ranked by growth rate： “If one invested in the slowest growing quintile of countries during this hundred-year- plus period， the equity returns would have outperformed the fastest growing quintile by three percent a year… Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly five percent a year.” China， naturally， was no exception， Goldman Sachs noted： “China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns… China’s economy has outgrown that of the U.S. by about eight percent a year since the end of 1992… Its equity market， however， has lagged that of the U.S. by about eight percent a year. Over the last 15 years， earnings per share growth in China has been a negative 0.9 percent while that of the S&P 500 companies has been 5.4 percent a year... Since the peak of U.S. and Chinese equities in October 2007， China has outgrown the U.S. by an estimated 10 percent a year， but Chinese equities have lagged the U.S. by 2.7 percent a year.”
Goldman Sachs concluded： “Whether it is one year， three years or 18 years， economic growth has not translated into better investment returns in China… The evidence shows that faster economic growth rates do not result in higher equity returns. In fact， if faster growth is priced into the equity markets， the equity markets are most likely going to lag those of slower growth economies.”
Why rapidly growing economies have badly performing shares is understood. It is because company resources are invested rather than distributed as dividends– therefore high dividends are positively correlated with high returns on shares， and rapid economic growth is negatively correlated. But for present purposes all that need be noted are the firmly established facts.
These are， of course， long-term correlations. They do not preclude purely short-term movements which contradict these trends， such as， for example， recent sharp gains in Shanghai. Furthermore， hedge funds and similar operators can make profits even in falling markets， and are particularly attracted by very sharp short-term movements such as in Shanghai last year.
Therefore， from share market theory， it would be expected that China’s share market would be profitable for short-term hedging operations， but it would be unsuitable for long-term investors seeking positive rewards. This is exactly how the Connect has functioned. It is therefore not in contradiction with but in line with share market theory.
The consequences are clear. China can have strong economic growth， or it can have a strongly performing share market. It cannot have both. Only a severe economic slowdown would lead to China having above average returns on shares – making it attractive for foreign investors. It is clear whether strong economic development or a high share market is most important for China. International comparisons show that 86 percent of growth in consumption， an indispensable basis of living standards， is accounted for by GDP growth. As China’s living standard is less than 20 percent of the U.S.， it is strong economic growth， not a strongly performing stock exchange， that is important for China’s population.
“Facts are stubborn things，” as the saying goes. Attempts to ignore the realities of stock market performance naturally do not alter the performance of these markets – as realities are much more powerful than inaccurate ideas.
Fortunately the sums traded under the ShanghaiHong Kong Stock Connect are too small to significantly affect China’s economy in either direction. But more damaging initiatives could result from wrong analyses of the relation between economic growth and share market returns. The Shanghai-Hong Kong Stock Connect is therefore of wider significance in showing the importance for China’s economic policy of understanding the real factual relation between economic growth and share market performance.