What’s the correlation between GDP growth and earnings growth?

Manas Chakravarty, Mint, 24/8/2011

source: http://www.livemint.com/2011/08/23221928/What8217s-the-correlation-b.html

Everybody knows that the growth in the gross domestic product (GDP) this year will be lower than last year. We also know that it will lead to lower earnings growth. The question is: how much lower? Real GDP growth in fiscal 2011 (FY11) was 8.5% and this fiscal, according to the latest estimate by Morgan Stanley, it’s going to be 7.2%. The government says it’ll be 8% or so.

Assuming it’ll be around 7.5%, how much lower will the earnings growth be? Citigroup Global Markets Inc. has brought out a report, The Asia Investigator— Where to with Earnings? that explores, among lots of other things, the relationship between GDP growth in the Asian nations and the growth in corporate earnings. Specifically, it finds out the impact of a 0.5 percentage point decline in nominal GDP growth on the corporate earnings growth. Note that it takes nominal and not real GDP because “top-line and bottom-line earnings are a nominal phenomenon, not real”.

The Citigroup analysts find that for India, a 0.5 percentage point downward revision in nominal GDP growth is associated with a decline of 2 percentage points in corporate earnings growth.

Well, assuming a 1 percentage point decline in real GDP growth estimates and no change in inflation expectations for FY12, that translates into a mere 4 percentage points decline in earnings growth. Citigroup estimates show that Sensex growth projections have been revised downwards from 23.6% in July to 20.1% in August. If the computation is correct, then, the necessary downward earnings revisions have more or less been done.

However, the chart shows the nominal GDP growth in the last six years along with the growth in Sensex earnings. As you can see, there’s hardly any correlation.

Another metric should appeal to the pessimists. The same Citigroup note shows that while currently its Country Earnings Revision Index is 1.16 standard deviations away from its mean, it was 1.68 standard deviations away from the mean during the 2000 downturn, 2.07 standard deviations down in 2008 and 1.38 standard deviations down during the Asian crisis. Simply put, according to this metric, earnings revision still has some way to go.

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