Explain how an assessment of trend economic growth feeds into long-run forecasts for asset returns
The idea
Potential GDP growth equals labour force growth plus labour productivity growth, or in growth accounting terms %ΔY = %ΔA + α × %ΔK + (1 − α) × %ΔL. Over long horizons aggregate corporate earnings cannot outgrow the economy indefinitely, so trend nominal GDP growth anchors earnings growth. A simple equity estimate is dividend yield plus nominal trend growth: 2% yield, 2% real growth and 2% inflation give roughly 6%. Trend growth also shapes real interest rates, since faster growth tends to require higher real rates. The trap is to plug in short-cycle growth rates, or to forget that earnings of listed companies can diverge from domestic GDP when revenues come from abroad or new firms dilute existing holders.
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