Since equitiesare claims on real assets, their long-term returns have compensated investors for changes in inflation and thus protected investors from exchange-rate risk. Therefore, it is not worth the cost for long-term stockinvestors to hedge their currency risk.
Sector DiversificationAlthough the returns between foreign and U.S. stocks might be increasingly correlated, the returns between international industrial sectors arenot becoming more correlated. The trends in correlations between themajor world industry sectors as classified by the Morgan Stanley Capital Market Indexes are shown in Figure 10-4.Sector correlation sunk rapidly in the late 1990s and reached a lowpoint in 2000 when the technology stocks soared while other sectors fell9See Kenneth A. Froot, “Currency Hedging over Long Horizons,” National Bureau of Economic Research (NBER) Working Paper No. 4355, Cambridge, Mass.: NBER, May 1993.
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FIGURE
10–4
Correlations of International Sectors and World Stock Returns1.00
0.80
0.60
0.40
0.20
0.00
-0.201995
Consumer DiscretionaryIndustrialsInfo TechTelecomFinancialsMaterialsEnergyUtilitiesHealthcareConsumer Staples
1996
1997
1998
1999
in price. But even after the tech bubble popped, sector correlations werelower than before. One reason for the decreased correlation between sectors is the moderation of the business cycle, which means that shifts insector demands, rather than changes in the overall economy, become theprimary sources of changes in firm profitability. What does it mean thatsector returns are not as correlated as in the past?I believe that a sector approach to international investing may supplant a country approach in coming years. It is true that government regulations and legal structures will still matter, even when most of thefirm’s sales, earnings, and production come from abroad. But thesehome-country influences will very likely diminish as globalization advances. In fact, I envision a future of international incorporations, wherefirms choose to be governed by a set of international rules agreed uponamong nations. This will be similar to the growing popularity of the accounting standards adopted by the International Accounting StandardsBoard (IASB) over country-based standards. If international incorporation gained prominence, there would be no meaning to “headquarteredcountry,” and investment allocations would have to be made on the
2000
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basis of global sectors, or by regions of production and distribution. Inthat case, a U.S.-only portfolio would be very narrow indeed.
Sector Allocation around the WorldLet’s take a closer look at the importance of these industrial sectors by region and by country. The 10 Global International Classification (GIC) industrial sectors in five geographic regions (United States, EAFE, Europe,Japan, and the emerging markets)10 are shown in Table 10-4, by the respective weight of each industrial sector. The 20 largest firms by market valueheadquartered in and outside the United States are shown in Table 10-5.11The financial sector is the largest sector in every region of the world.This demonstrates how commercial and investment banks, insurancecompanies, and brokerages are critical to economic growth. The largestshare of the financial market value sector is found in Europe, belongingto companies such as HSBC, UBS, and the Royal Bank of Scotland. Thepartial privatization of the Bank of China, the Industrial and Commercial Bank, and the China Construction Bank have also made this sectorthe largest in the emerging markets. In the United States, the largest financial firms are Citigroup, Bank of America, and AIG.10
The United States is represented by the S&P 500 Index, and the non-U.S.-developed regions arerepresented by the EAFE Index (described in footnote 6), Europe (iShares S&P Europe 350, symbolIEU), and the emerging market (iShares MSCI Emerging Markets Index, symbol EEM).11The chapter appendix gives a brief discussion of the 10 largest non-U.S.-based stocks, ranked bymarket capitalization. All these are ranked by total market value, including all government holdings.
TABLE
10–4
Sector Allocation in World Regions
Consumer DiscretionaryConsumer StaplesEnergyFinancialsHealthcareIndustrialsInformation TechnologyMaterialsTelecommunication ServicesUtilities
S&P 500
EAFE
Europe
Japan
10.2%9.4%10.6%21.3%11.8%11.3%15.2%3.1%3.8%3.5%
12.0%7.9%7.2%29.2%6.4%12.0%5.3%9.4%5.3%5.4%
9.0%9.2%9.9%31.1%7.4%8.4%3.5%8.2%6.4%6.9%
20.0%4.5%1.1%20.7%5.5%18.4%12.7%9.8%3.0%4.3%
EmergingMarkets4.3%3.8%15.2%21.1%2.0%4.8%16.2%15.3%12.5%4.8%
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TABLE
10–5
Top 20 U.S. and Foreign Companies by Total Market Value in June 2007
In the consumer discretionary sector, Japan has by far the highestweight of all geographic regions, primarily because of the presence ofToyota Motors, one of the largest non-U.S.-based corporations in theworld. This sector covers companies that produce products that consumers generally buy with discretionary income. Sony Corporation,Honda Motor, and Matsushita Electric Industrial also contribute to thissector. In the United States, the largest firms in the consumer discretionary sector are Comcast, Time Warner, and Home Depot while in Europe DaimlerChrysler is the largest.
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The United States has the largest weight in the consumer staplessector, closely followed by Europe. Here the big firms in the UnitedStates are Procter & Gamble, Altria, and Wal-Mart, while in Europe thedominant firms are Nestlé, Unilever, and British American Tobacco. Theemerging markets have few entries in this sector while Japan has virtually no presence relative to the size of its market.The energy sector has a large value everywhere but in Japan, whichhas very little in energy resources. In the United States the integrated oilproducers such as Exxon Mobil, Chevron, and ConocoPhillips dominate,while in Europe the largest firms are BP (British Petroleum), Total in France,and ENI in Italy. Energy firms in the emerging markets are dominated bythe Chinese PetroChina, the largest foreign firm, and Russian Gazprom, thesecond largest. Both these firms are only partially privatized.Healthcare has the largest share of U.S. firms and the smallest sharein the emerging markets. In the United States, the largest firms arePfizer, Johnson & Johnson, and Merck; in Europe, GlaxoSmithKline, AstraZeneca, Roche, and Novartis; while in Japan, Takeda Pharmaceuticalis predominant.The share of industrial firms is largest in Japan and smallest in theemerging markets. Mitsubishi and Mitsui dominate in Japan; Siemensand Deutsche Post in Europe, and General Electric in the United States.Information technology has the highest share in the emerging markets, but this is almost entirely due to the Asian giants Samsung Electronicfrom South Korea and Taiwan Semiconductor. If we exclude firms fromSouth Korea and Taiwan, then India has nearly 80 percent of the remainingmarket value of technology firms with Infosys and Wipro being the largest.By far the largest sector share for telecommunications firms isfound in the emerging markets, due to Chunghwa Telecom of Taiwan,América Móvil, S.A.B. de C.V. of Mexico, and China Mobile. In EuropeVodafone is the largest telecommunications firm, followed by the Spanish Telefonica and Deutsche Telekom. In the United States the largestfirms are AT&T and Verizon.Finally, utility firms have a small share of only 31⁄2 percent in the U.S.market (led by Exelon Corp.), an electric utilities firm, to nearly 7 percentin Europe led by Enel of Italy and Electricité de France, the tenth-largestforeign firm.
Private and Public CapitalExxon Mobil may be the largest company by market value in the world,and it has the largest reserves of oil and gas (20 billion barrels) of any
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private company. But if one includes government-owned companies,this U.S. giant is only the fourteenth largest.12 Saudi Arabia’s Aramcoand Iran’s NIOC have reserves of about 300 billion barrels! If one wereto value these reserves at only $3.30 a barrel, or 5 percent of the 2007price, that would make each company worth about $1 trillion. Thatshows how much wealth is still owned by governments around theworld. In many countries, gas, electric, and water facilities are stillowned and operated by government, and in many other industries, governments have a large, if not a controlling, interest.Even in such privatized countries as the United States, the federal,state, and local governments own trillions of dollars of wealth in suchforms as land, natural resources, roads, dams, schools, and parks. Thereis strong disagreement about how much of this wealth, if any, should beprivatized. But there is increasing awareness that privatized firms oftendo experience efficiency gains. Growth of the world’s capital stock willcome not only from private entrepreneurs but from the privatization ofmany government-owned assets.
THE WORLD IN 2050We began this chapter with a look at the distribution of population, output, and equity capital worldwide. Through most of the twentieth century, the developed world produced most of the world’s output andgenerated an even larger share of its capital.But this dominance will not last. The success of market-orientedeconomies in the last century provided a blueprint for the next. Twentyfive years ago, China came around to accept the benefits of a marketeconomy. Fifteen years later, India did the same. The collapse of communism in the former Soviet Union and Eastern Europe has broadenedthe list even further. And many countries in Latin America, although notall, have adopted the free-market principles that have given Chile thesecond highest per capita income on the continent.The Middle East and Africa have most certainly lagged. The Middle East is addicted to oil revenue and sectarian strife, and Africa isslowly emerging from a dark period of misrule and exploitation. Buthere too there has been some progress: the remarkable growth of Dubaihas shown the Arab world that oil need not be the cornerstone of prosperity, and Africa is experiencing increased economic activity. There is
12
From Steve Forbes, “Fact and Comment,” Forbes, April 16, 2007, pp. 33–34.
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even a freshly minted acronym for this region: MENA, or Middle Eastand North Africa.These developments will lead the world to be a very different placeby midcentury. By making conservative projections of productivitygrowth throughout the world and combining these assumptions withthe population data compiled by the U.N. Demographic Commission,we can project the distribution of population, GDP, and equity capital bymidcentury, as shown in Figures 10-5a, b, and c.13As one can see in Figure 10-5b, the share of economic output in thedeveloped world will shrink dramatically: from more than one-half ofthe world’s output to about one-quarter by midcentury. The UnitedStates’ share will shrink from 19 to 12 percent, Western Europe’s from 19to 9 percent, and Japan’s from 6 to 2 percent. Well before midcentury,13
Average productivity growth from 2006 through 2050 in the developed world, 2.5 percent ; Chinaand Indonesia, 5.0 percent; India, 5.5 percent; other Asia and Eastern Europe, 4.5 percent; LatinAmerica and Caribbean, 4.0 percent; Middle East and Africa, 3.5 percent. The value of equity wasdetermined by regression analysis of equity markets against the GDP.
FIGURE
10–5a
The 2050 World Population
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FIGURE
10–5b
The 2050 World GDP
FIGURE
10–5c
The 2050 World Equity
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China will become the world’s largest economy (projections range from2025 to 2030), and in 2050, it will command 23 percent of the world’s output, equal to the combined production of the United States, Western Europe, and Japan. India will not be far behind with an economic share of15 percent, and India and China will be producing more than one-thirdof the world’s output.Although the overall economy of China will eclipse that of theWest, this does not mean that the average Chinese worker will be betteroff than the average European, Japanese, or American. China’s population is projected to be about 31⁄2 times that of the United States, and its percapita income at about one-half that level. If Chinese productivity growthexceeds expectations and per capita income rises to 60 percent of the U.S.level, China’s GDP will increase to over 25 percent of the world total.The astounding rise of China and India will bring the distributionof output more in line with the distribution of population. It has beenestimated by economic historians that in the seventeenth and eighteenth centuries, the combined economies of India and China wereabout one-third that of the entire world.14 But for political reasons, boththese giants went into eclipse, while the Industrial Revolution began inEurope and was exported to the United States. Now India and Chinamay once again become economic leaders of the twenty-first century.The radical shift in the distribution of output will also bring abouta redistribution of capital. Based on my analysis of the relation betweenthe size of a country’s equity markets and its GDP, I was able to projectwhere the world’s equity capital will be headquartered at midcentury.The developed world, which now comprises over 90 percent of theworld’s total stock market value, will shrink to slightly more than onethird. Not only will large amounts of capital be created abroad but, asnoted in the last chapter, Western capital will be sold to the emerging nations in exchange for the goods that aging economies will need.Investors should be warned that the increase in a country’s share ofworld capital shown from Figure 10-1c to Figure 10-5c does not necessarily represent capital appreciation of existing shares. Rather, most ofthe increases come from the flotation of new capital as well as the acquisition of old capital. As we learned in the last chapter, economic growthdoes not guarantee good returns, and in fact, the evidence indicates thatinvestors pay too high a price for stocks in fast-growing countries.
14
Angus Maddison, Chinese Economic Performance in the Long Run, Organisation for Economic andCo-operation Development, Paris: OECD Development Centre, 1998.
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CONCLUSIONThe inexorable trend toward integration of the world’s economies andmarkets will certainly continue in this new millennium. No country willbe able to dominate every market, and industry leaders are apt toemerge from any place on the globe. The globalization of the worldeconomy means that the strength of management, product lines, andmarketing will be far more important factors in achieving success thanwhere the firm is domiciled.Sticking only to U.S. equities is a risky strategy for investors. No advisor would recommend investing only in those stocks whose name begins with the letter A. But sticking only to U.S. equities would be justsuch a bet since U.S.-based equity will likely shrink to less than 18 percent of the world market by midcentury. And equity in China and Indiawill grow to more than one-third of the world’s equity market and betwice the size of the United States. Only those investors who have a fullydiversified world portfolio will be able to reap the best returns with thelowest risk.
APPENDIX: THE LARGEST NON-U.S.-BASED COMPANIESTable 10-5 lists the top 20 U.S. and non-U.S. companies by total marketvalue, based on all shares outstanding (not float adjusted, whether partially owned by the government or not).
1. PetroChina (China)PetroChina is a subsidiary of the state-owned China National Petroleum Corporation, and it produces two-thirds of China’s oil and gas.The company has 11.5 billion barrels of oil reserves and has interestsin over 15,900 gas stations. PetroChina was created in 2000 to manageChina’s domestic petroleum production. As of October 2007, its market value has soared to $438 billion, second in the world to ExxonMobil.
2. OAO Gazprom (Russia)Gazprom, Russia’s largest company, is an oil and gas giant that controls25 percent of the world oil reserves. Its revenues account for 25 percentof the Russian government’s tax revenues. Initially a state-owned natural gas monopoly, Gazprom was converted into a joint-stock company in
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1993. The state first had a 40 percent share, which was boosted to 51 percent in 2003. Gazprom offered 1 percent of its stock to foreigners in 1996.
3. Royal Dutch Shell (the Netherlands)The company known today as Royal Dutch Shell was formed from themerger of two global oil conglomerates in 2003—Royal Dutch Petroleum(founded by a Dutchman in 1890) and Shell Transport and Trading(founded by an Englishman in 1897)—that have been in a close relationship for over a century. Royal Dutch has oil and gas operations in over27 countries, and it sells its products to over 130 companies. Its 2006sales were over $320 billion.
4. BP (British Petroleum) (United Kingdom)Like its competitors Royal Dutch Shell, Exxon Mobil, and ConocoPhillips, today’s BP comes from the recent merger in 1993 of two massive oil conglomerates—British Petroleum, founded in 1911, and Amoco,a spin-off of the Standard Oil Trust in 1911. BP is a multinational, earning 29 percent of its revenue from its native United Kingdom, 31 percentfrom the United States, and 22 percent from Continental Europe. AsBritain has very few oil reserves, production is accomplished almost entirely abroad. Its 2006 sales were over $260 billion.
5. China Mobile (China)China Mobile serves almost 300 million subscribers in China, and it enjoys a 67 percent market share. It’s the world’s leading wireless companyby subscribers. Like many other modern Chinese corporations, ChinaMobile was once part of a state-owned monopoly but is now publiclytraded. As of October 2007, its total market value soared to $370 billion.
6. Toyota Motor Corporation (Japan)The largest foreign company by market value is Toyota Motor, foundedin 1926 as Toyoda Loom Works by Sakichi Toyoda. In 1950 the companywas reorganized into Toyota Motor Corporation, and in 2008 it willovertake General Motors as the leading automobile manufacturer in theworld. Toyota, which has recently expanded into financial services, produces automobiles in 27 different countries, and only 37 percent of itsautomobiles are produced in Japan.
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7. Industrial and Commercial Bank of China (ICBC) (China)For most of its history, ICBC was the state-owned commercial bank inthe People’s Republic of China. On October 28, 2005, ICBC was transformed from a state-owned enterprise to a shareholding company, withthe Chinese Ministry of Finance and SAFE Investments Limited eachholding 124 billion shares. In 2006, ICBC set the record for the largest initial public offering in history, with a $21.9 billion sale on the Hong Kongand Shanghai exchanges; 83.5 percent of the shares are still governmentowned.
8. HSBC Holdings (United Kingdom)HSBC was founded as the Hong Kong and Shanghai Bank by a group ofHong Kong businessmen led by Thomas Sutherland in 1865. In 1955 theShanghai office was closed, and in 1993 the bank moved its official headquarters to London in anticipation of the Chinese takeover of HongKong. HSBC has over 10,000 offices in over 80 countries and assets ofover $1.8 trillion.
9. Total (France)The French oil company Total began in 1924 as the Compagnie Françaisedes Pétroles (CFP). It created the brand name Total in 1954 and adoptedit as the name of the company in 1991. Total is a vertically integrated oilcompany with reserves in Indonesia, Argentina, Colombia, and theNorth Sea. The oil company has operations in over 130 companies andearns less than one-quarter of its revenue from France.
10. Electricité de France (EDF) (France)EDF was formed from the nationalization of private utilities in 1946. TheFrench government sold 15 percent of EDF to the public in 2005, and itderegulated 70 percent of the market. EDF was primarily a hydroelectricproducer, but it now operates many nuclear power plants. The companyearns 63 percent of its revenues from France and about one-third fromother European countries, including the United Kingdom.
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GOLD, MONETARY POLICY,AND INFLATIONIn the stock market, as with horse racing, money makes the mare go.Monetary conditions exert an enormous influence on stock prices.MARTIN ZWEIG, 19901
If Fed Chairman Alan Greenspan were to whisper to me what hismonetary policy was going to be over the next two years, it wouldn’tchange one thing I do.WA R R E N B U F F E T T, 1 9 9 4 2
On September 20, 1931, the British government announced that Englandwas going off the gold standard. It would no longer exchange gold foran account at the Bank of England or for British currency, the pound sterling. The government insisted that this action was only “temporary,”that it had no intention of forever abolishing its commitment to exchange its money for gold. Nevertheless, it was to mark the beginning of12
Martin Zweig, Winning on Wall Street, updated ed., New York: Warner Books, 1990, p. 43.Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 30, 1994, p. 59.187
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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the end of both Britain’s and the world’s gold standard—a standard thathad existed for over 200 years.Fearing chaos in the currency market, the British government ordered the London Stock Exchange closed. New York Stock Exchange officials decided to keep the U.S. exchange open but also braced for panicselling. The suspension of gold payments by Britain, the second-greatestindustrial power, raised fears that other industrial countries might beforced to abandon gold. Central bankers called the suspension “a worldfinancial crisis of unprecedented dimensions.”3 For the first time ever,the New York Exchange banned short selling in an effort to shore upstock share prices.But much to New York’s surprise, stocks rallied sharply after ashort sinking spell, and many issues ended the day higher. Clearly,British suspension was not seen as negative for American equities.Nor was this “unprecedented financial crisis” a problem for theBritish stock market. When England reopened the exchange on September 23, prices soared. The AP wire gave the following colorful description of the reopening of the exchange:Swarms of stock brokers, laughing and cheering like schoolboys, invadedthe Stock Exchange today for the resumption of trading after the two-daycompulsory close-down—and their buoyancy was reflected in the pricesof many securities.4
Despite the dire predictions of government officials, shareholdersviewed casting off the gold standard as good for the economy and evenbetter for stocks. As a result of the gold suspension, the British government could expand credit by lending reserves to the banking system,and the fall in the value of the British pound would increase the demandfor British exports. The stock market gave a ringing endorsement to theactions that shocked conservative world financiers. In fact, September1931 marked the low point of the British stock market, while the UnitedStates and other countries that stayed on the gold standard continuedto sink into depression. The lessons from history: liquidity and easycredit feed the stock market, and the ability of the central banks to provideliquidity at will is a critical plus for stock values.A year and a half later, the United States joined Britain in abandoning the gold standard, and finally every nation eventually went to a fiat,paper money standard. But despite the new standard’s inflationary bias,34
“World Crisis Seen by Vienna Bankers,” New York Times, September 21, 1931, p. 2.“British Stocks Rise, Pound Goes Lower,” New York Times, September 24, 1931, p. 2.
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the world has become comfortable with the new standard and enjoys theflexibility it accords policymakers.
MONEY AND PRICESIn 1950, President Truman startled the nation in his State of the Unionaddress with a prediction that the typical American family incomewould reach $12,000 by the year 2000. Considering that median familyincome was about $3,300 at the time, $12,000 seemed like a princely sumand implied that America was going to make unprecedented economicprogress in the next half century. In fact, President Truman’s predictionhas proved quite modest. The median family income in 2000 was$41,349. However, that sum buys less than $6,000 in 1950 prices, a testament to the inflation of the last half-century. So instead of the typicalfamily income soaring over 12 times, from $3,300 to $41,349 in roughlyhalf a century, real incomes have only doubled, from $3,300 to $6,000, because of the inflation bite.Inflation and deflation, which is defined as falling prices, havecharacterized economic history as far back as economists have gathereddata. However, in the last 60 years there has never been a single year inwhich the U.S. consumer price index has declined. What has changedover the past half century that makes inflation the rule rather than theexception? The answer is simple: control of the money supply hasshifted from gold to the government. With this shift, a whole new system has come into being that connects money, government deficits, andinflation.The overall price level in the United States and Great Britain overthe last 200 years is displayed in Figure 1-3 in Chapter 1. It is strikinghow similar the general trends are in these two countries: no overall inflation until World War II and then protracted inflation after. Before theGreat Depression, inflation occurred only because of war, crop failures,or other crises. But the behavior of prices in the postwar period has beenentirely different. The price level has almost never declined: the onlyquestion is at what rate will prices rise.Economists have long known that one variable is paramount in determining the price level: the amount of money in circulation. The robust relation between money and inflation is strongly supported by theevidence. Take a look at Figure 11-1, which displays money and pricesin the United States since 1830. The overall trend of the price level hasclosely tracked that of the money supply normalized for the level ofoutput.
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PART 3 How the Economic Environment Impacts Stocks
FIGURE
11–1
Money and Price Indexes in the United States, 1830 through December 2006
The strong relation between the money supply and consumerprices is a worldwide phenomenon. No sustained inflation is possiblewithout continuous money creation, and every hyperinflation in historyhas been associated with an explosion of the money supply. There isoverwhelming evidence that countries with high monetary growth experience high inflation, while countries with restrained money growthhave low inflation.Why is the quantity of money so closely connected to the pricelevel? Because the price of money, like any good, is determined by supply and demand. The supply of dollars is printed by the central bank.The demand for dollars is derived from the demand of households andfirms transacting billions of dollars of goods and services in a complexeconomy. If the supply of dollars increases more than the number ofgoods produced, this leads to inflation. The classic description of the inflationary process—“too many dollars chasing too few goods”—is as apttoday as ever.
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THE GOLD STANDARDFor the nearly 200 years prior to the Great Depression, most of the industrialized world was on a gold standard. This meant that, for example, the U.S. government was obligated to exchange dollars for afixed amount of gold. To do this, the U.S. and other governments hadto keep gold reserves in sufficient quantity to assure money holdersthat they would always be able to make good on this exchange. Sincethe total quantity of gold in the world was fixed—new gold discoveries were relatively small and contributed insignificantly to theworld’s total gold supply—prices of goods generally remained relatively constant.The only times the gold standard was suspended was during crises,such as wars. Great Britain suspended the gold standard during both theNapoleonic Wars and World War I, but in both cases it returned to thegold standard with the original parity price. Similarly, the United Statestemporarily suspended the gold standard during the Civil War, but it returned to the standard after the war ended.5The adherence to the gold standard is the reason why the world experienced no overall inflation during the nineteenth and early twentiethcenturies. But overall price stability was not achieved without a cost. Byequating the money in circulation to the quantity of gold available, thegovernment essentially relinquished control over monetary conditions.This meant that the central bank was unable to provide additionalmoney during economic or financial crises or when the economy grewin size. In the 1930s, adherence to the gold standard turned from beingan exercise