Investors are willing to pay more for a business relative to its profits if they believe it will grow a lot in the future. It might have a good management team investing money wisely, or maybe, as with Nvidia, it has developed a new technology.
This relationship isn’t perfect, though. Company valuations can become unmoored from their underlying business if there is unjustified hype, and these bubbles can persist for a while. But if a company’s valuation increases, at some point its earnings will have to start rising. If this doesn’t happen, then its share price will come down, often in a crash.
Similar to an income statement, the gross domestic product (GDP) is the output of the country. However, instead of measuring one business, it measures every person, government agency and company. All the transactions for the year get added up and used as a measure of the economic health of nation.
The other way to look at the economic well-being of a nation is to look at wealth. Unlike GDP, wealth is a one-off measure of the value of all the assets in the economy. In the case of household net worth, it is all the assets held by people minus their liabilities. This includes housing, stocks, bonds, and pensions.
Like a company’s stock price, a country's wealth is a forward-looking figure and should reflect the expected future output of an economy. “Macroeconomic theory generally predicts that, in a stable economy wealth and GDP should comove tightly such that the wealth-to-GDP ratio converges to a roughly constant value,” said Federal Reserve of St Louis economist YiLi Chien.
The only time this ratio should diverge significantly is if there is a shock to the economy that means GDP growth will move away from its recent trend. For example, if a country discovers a new oil reserve and joins a large trading bloc, cash will start rushing into the country. The homeowners in that country can now increase rent, meaning the expected future cash flow of those properties rise. Property investors will then be willing to pay a higher price for the houses.
In the past eight years, the US’s relationship between GDP and wealth has become unmoored. In 1995, the total household net worth in the US was $26trn, which was 3.6 times larger than its $7.5trn of GDP. Between 1995 and 2012, this ratio was consistently below 4.2. It briefly hit 4.5 in 2007, before the financial crash collapsed asset prices.
However, since 2014 the ratio has been increasing consistently. It peaked at 5.8 in mid-2021, before interest rate tightening brought it down to 5.1. However, in the last few quarters household wealth has risen to over $150trn, with its ratio to GDP hitting 5.4 last quarter.
To bring this ratio back closer to its medium-term average, either the US GDP growth is going to have to accelerate, or its asset valuations must fall. The main argument for growth is that the emergence of AI will generate productivity gains across the economy, that will outweigh the headwinds of ageing populations, increased trade barriers and receding globalisation.
However, recent history suggests that rather than being a precursor to a surge in GDP growth, this ratio will correct through an asset price decline. As the chart shows, the last two times this ratio increased significantly was in the run-up to the Dot Com Bubble in 2000 and then the Global Financial Crisis in 2008. In both cases, the US economy fell into a recession but the fall in wealth was even more significant.
There is a possibility that an unknown structural change in the economy has permanently shifted this ratio higher. Chien hypothesised that internet companies such as Facebook, Instagram and Google are free to use so they don’t have all their utility captured in the GDP metric. Yet, a huge amount of wealth has been generated through their rising stock prices.
The concern is nothing has changed, and this time the rise in US wealth has happened over a much larger period. The simple analysis suggests, the higher something rises, the further it must fall.
