Indices aren’t economies

Prospects for global growth have dimmed and uncertainty is rife, but global equity markets have powered ahead since the ceasefire between the US and Iran on 8 April. Things can change quickly, but on Friday the US S&P 500 index closed at a new high, up 12% since the low reached at the end of March.

The apparent disconnect between economic risk and the performance of equity indices may seem paradoxical, but it is, if anything, normal. What’s good for an economy can often have little if any effect on its equity market – and vice versa. Equity indices only partially and weakly, reflect the composition of their host economies.

The major indices, such as the FTSE 100, the S&P 500 and the German DAX are dominated by a small number of large, multinational companies. Most of what drives GDP growth – the activities of unquoted businesses, large and small, which employ the bulk of the workforce, public sector activity along with wages and salaries – are not captured in equity indices. Swathes of economic activity play no role in equity markets. Of the 5.3 million registered UK companies in 2024-25, for instance, only 0.1% were quoted.

Equity indices also exaggerate the importance of a handful of sectors. Soaring valuations in a sector that makes up a small share of GDP give it outsize weight in an equity index. Technology accounts for more than a third of the S&P 500 but only about 10% of the US economy.

Whereas GDP measures what is produced within a country’s borders, equity markets capture the sales of constituent companies wherever they take place. The UK FTSE 100 has long been seen by international investors as a play on global equity markets, and never more so than today with foreign revenues accounting for roughly three quarters of FTSE 100 earnings. The trade intensity of GDP is lower in the US than in the UK, but about a third of S&P 500 earnings come from outside the US.

There are two other important differences.

First, GDP measures current economic activity while equities reflect what investors are prepared to pay for future earnings, which itself depends on expectations for earnings and interest rates.

Second, fast-growing economies need more capital, which often takes the form of companies issuing new shares. Strong GDP growth boosts company earnings, but these are spread across a growing number of shares. Existing shareholders lose out, depressing valuations. Such earnings dilution helps explain why equity returns in China have underperformed those in many western markets where companies, far from issuing new equity, have been buying them back to bolster earnings and valuations.

For all these reasons history is littered with examples of equity markets going up in the face of less-than-spectacular rates of domestic growth.

US equities have delivered higher returns than Chinese equities in the last 30 years despite the size of the Chinese economy increasing ten times faster than America’s.

UK GDP has risen by around 1.5% since January 2025 while the broad equity market has risen 28%.

Despite the raging pandemic and a shrinking economy US equities ended 2020 up 16% buoyed by collapsing interest rates and expectations of a strong recovery.

Exceptional returns from South African equities in the 20th century were driven by mining and commodity stocks whose price is set by global conditions, not by relatively slow South African growth rates.

Equity markets perform a host of economically important functions, and their performance provides vital insights into the financial economy. They have much less to say about the performance of underlying economies.