Economies and stockmarkets do not always match up well
EVERYBODY KNOWS Monty Python’s “cheese shop” sketch—everybody who is over 50 and a comedy nerd, that is. The shopkeeper, played by Michael Palin, asks a customer, played by John Cleese, what cheese he would like. Do you have Red Leicester? Sold out. Caerphilly? On order. Cheddar? Not much call for it. Each increasingly testy request for a different cheese (43 of them) is cheerfully met with a “no”, “sorry” or feeble excuse. Pressed to back up his claim to the best cheese shop around, the shopkeeper replies: “Well, it’s so clean, sir!”
This leads us, as smoothly as a Python segue, to a frequent complaint about the main stock index for investors in emerging markets. The opportunity is as clear as a sign saying “Cheese Shop”. Most of the growth in the world’s GDP over the next five years will be in developing countries, says the IMF. You might like to buy a basket of stocks from a broad range of countries that taps into this growth. But the benchmark MSCI emerging-market index does not really offer that.
It is light on exposure to the fastest-growing bits of the world economy, notably in Africa. Instead it has a heavy tilt towards economies in the Asian supply chain to rich-world consumers. In short, it looks to some investors like a cheese shop that is so clean because it is uncontaminated by cheese. Yet the trouble lies not with the index compilers, but with the nature of public markets.
The matter turns on the different ways in which economies and markets are classified. With countries, it mostly comes down to income level: if GDP per person is above a certain threshold, an economy counts as developed. The criteria for financial-market development are different. Here, what matters is how easy it is for foreign investors to move large sums into and out of local stocks. That in turn depends on two things. The first is the stockmarket’s liquidity: the bigger the market, the better equipped it is to handle big purchases or sales of stock on any given day. The second is openness. A market with lots of biggish listed stocks, which trade frequently, might still fail to qualify for developed-market status because it has limits on foreign ownership or other barriers to cross-border trading.
Take South Korea, for instance. Decades of sustained growth turned it into a rich country, with GDP per person of $ 31,000 at current exchange rates. Yet its currency can be bought and sold only in Korea, and only during local market hours. It cannot be traded offshore. That may seem like a minor matter. But index funds that move vast sums to and fro quickly like to do their currency trades in one go. Developed stockmarkets are defined by the absence of such frictions, says Sebastien Lieblich, of MSCI. Though Taiwan is richer than Portugal, and Korea’s GDP is bigger, they are both classified by MSCI as emerging markets. Together they account for a quarter of the index. Add in the 33% weight for Chinese stocks and its constituents lean heavily towards “Factory Asia”.
A stock index measures what is investable. If you are seeking exposure to broad-based economic development, you need to be creative. That means looking at smaller, less liquid stocks outside the index, or perhaps the shares of rich-world firms that earn the bulk of their revenue in developing countries. The alternative is to drop down a level in terms of liquidity and openness to “frontier markets”, which include fast-growing economies in Asia, such as Bangladesh and Vietnam, but also in Africa. This is a much smaller universe of stocks. The market capitalisation of MSCI’s frontier-market index is around $ 120bn, compared with around $ 5trn for its emerging-market index. And it is also dominated by a few countries. Stocks listed in Kuwait, Vietnam and Argentina account for more than half of it.
Economies and stockmarkets do not match up well, even in rich countries. America accounts for 55% of MSCI’s world index but a much smaller share of the world economy. The size of its equity market relative to GDP is at one extreme (along with Britain and Switzerland), notes Victor Haghani of Elm Partners, with Germany and Italy at the other. The best reason for investing across borders is not to plug into faster GDP growth (for which you may overpay), but for diversification. By owning a broad range of stocks, investors leave themselves less exposed to specific company, industry or country risks. The best thing about indices of big, liquid stocks is that buying and selling them is cheaper. For the only thing that grates more than Parmesan is high-cost investing.