There is much twaddle spoken about finance and economics. Take the eurozone growth figures released on Tuesday and the reaction in stock markets. For starters, it is flat out wrong to report that the economies of Germany and France did not contract in the second quarter – that the former expanded 0.3 per cent from April to June versus the first quarter while the latter remained flat was taken positively by markets. But these were preliminary data. The small print out of Germany’s federal statistics office admits provisional gross domestic product results can “fall below or exceed final results” by up to half a percentage point before the final numbers come in. Likewise, the Insee in Paris calculates that the average revision to its GDP data after three years is 0.3 percentage points.
In other words, both the German and French economies may well have contracted over the second quarter. We will not know for sure for years. For now, investors simply need to understand that there is not much growth around. They would be wrong to celebrate any uptick in eurozone activity, though. Just as commentators simplify the economic facts, stock pickers forget what matters to share prices. Equity valuations are more sensitive to discount rates than they are to small changes in revenue assumptions.
Hence any rise in interest rates on the back of a sudden recovery in eurozone GDP would hit equities hard. Consider a simple company growing sales at 3 per cent, making free cash flow of $4m with an equity risk premium of 5 per cent, a beta of 1, and no debt. Assuming 10-year government bond yields at 2 per cent, it would be worth about $125m. Lifting revenue growth to 4 per cent and bond yields to 4 per cent, however, wipes away a fifth of the company’s value. Unfortunately, investors never get the better times ahead without the higher rates.