GDP: A Better Benchmark?

Investors and portfolio managers with an absolute return objective typically rely on market or yield-derived benchmarks when evaluating investment performance. But is this the best approach?

Two of the most commonly used measures for assessing performance are volatility-adjusted returns relative to indexes such as the S&P 500 or benchmarks centered on the absolute returns realized by certain subgroups of investors. Arguably, such comparisons may be illogical given the implicit promise of “absolute return.” In both cases, performance evaluation and, therefore, portfolio allocation and securities selection preferences may be unduly influenced by random noise, structural inefficiencies, reputational biases, and other vagaries of the financial world. Short-term considerations end up muddying long-term perspectives.

In contrast, a benchmark based on overall economic activity may be more suitable and confer significant advantages for investors. Such a gauge helps define what returns are attractive relative to societal wealth creation and, importantly, which are economically feasible. It also helps to set realistic expectations that can reduce the temptation and, in some cases, the compulsion to chase potentially overvalued investments that are appreciating in price, thus alleviating certain of the risks associated with near-term volatility. An economically-derived yardstick should also encourage investors to weigh the merits of an investment relative to the outlook for demographic, productivity and inflation trends, as well as expectations regarding the relationship of investment income to wages and other earned income.

One key assumption, of course, is that asset values, as represented by equities, fixed-income and other classes, are intrinsically tied to a society’s productive capacity. While it is virtually inevitable that one or more companies, subsectors or industries will perform better (or worse) than the overall economy for some period of time, it is not feasible that most or all businesses will do so, especially over the longer term. Specifically, if one accepts that a nation’s ability to generate income and increase wealth is a function of its output of goods and services, it would be difficult, if not impossible, to argue that corporate America can garner a larger share than what is available.

With this in mind, it would seem that the most relevant benchmark for U.S. investors to use when evaluating investment performance is the well known yardstick of productive capacity, gross domestic product, or GDP.  Some might argue that gross domestic income, or GDI, which represents the sum total of income, profits, rent and interest being generated in the economy, is more appropriate, but the reality is that GDP and GDI are, for practical purposes, the same thing. While GDP measures the value of the output of goods and services, GDI measures the income derived from this production. For every sale—that is, GDP—there is a corresponding amount of income—GDI.

To be sure, the composition of national income needs to be understood. If the relative proportions of income, profits, rents and interest remain fixed, then the return potential for capital and savings—profits and interest—will, in fact, be the same as the nominal growth rate of GDP. However, history suggests that the relationship is not constant. Therefore, the potential for relative shifts between the four components could prove to be a critical consideration for investors. But factoring in such changes would be no different than accounting for variations in other important drivers, including labor productivity.

Regardless, with an economically-derived yardstick, U.S.-based investors could establish realistic and potentially achievable investment objectives. The long-term goal would be to generate returns after taxes and fees that exceeded the average annual compound growth rate of nominal GDP. If returns outpaced that target, investors would be doing better than the U.S. overall and their financial wealth would be growing at a rate in excess of increases in aggregate income. Such a gauge would provide a simple and uniform means for evaluating different opportunities and for forecasting average returns.

One objection to using such a yardstick is that a number of companies, especially the blue chip multinationals that comprise a significant share of U.S. stock market capitalization, have operations that span the globe and hence, are less tied to U.S. growth prospects than, say, smaller or domestically-focused firms. Indeed, foreign sales are thought to account for a third or more of S&P 500 company revenues. Nonetheless, the U.S. represents more than 20% of global GDP, and while some might argue otherwise, the maxim, “When America sneezes, the world catches a cold,” still seems as relevant as ever.

Others might wonder about the consequences of rising (or falling) price levels. There’s little doubt that inflation-adjusted growth is what matters to most people, whether they are workers, managers or policymakers, but it can be difficult to isolate or disentangle the inflationary components of nominal output data, especially insofar as the broad economy is concerned. It is not uncommon, for example, to see rises in inflationary expectations spurring an increased pace of consumer spending or business investment, and vice versa. At the company level, there is often no clear sense of which aspect of input or output prices represents the inflationary component. All of this argues for the simplicity of a nominally-oriented measure.

Finally, and most importantly to some, such a benchmark does not really take the notion of risk into account. Indeed, it’s a universal truth that investors, like everyone else, must balance risks versus rewards when making decisions about the future. Even so, it could be argued that risk tolerance is largely a matter of individual preferences and circumstances, as well as a function of the chosen investment horizon. Investors may decide, for example, that standard barometers of risk are inconsistent with a genuine long-term perspective. Although it is common practice to use the same gauge for assessing performance as for evaluating risk, that may not be the only or best approach.

Assuming that an economically-derived benchmark is appropriate, what should investors be expecting in terms of future returns? Over the past 10 and 20-year periods, for instance, the average annual pace of U.S. nominal GDP growth has been 3.6% and 4.5%, with inflation running at two and 1.9 percentage points, respectively. Since the data series began in 1929, nominal growth has averaged 6.4%, with inflation equaling 2.9 percentage points. Although there are no guarantees that the future will mirror the past, it is not unreasonable to assume that nominal GDP growth will be in the range of 4.5% to 6.5% over the longer term. Such an outlook would be consistent with annual population growth of just under 1%, annual productivity increases of 1.5% to 2.5%, and inflation rates of 2% to 3%, suggesting net after-tax expected returns of 5.5%.

That said, it wouldn’t be surprising to see growth rates for certain developing countries and regions, measured in local currency terms, prove to be marginally better than that of the U.S. and other mature economies, aided in part by greater productivity gains and a more liberal tolerance for rising prices. Even so, that shouldn’t take away from the fact that when it comes to thinking about the future, investors might find that anchoring expectations around an economically-derived benchmark is the better approach.

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