Research

“IT’S A (NOT SO) SMALL WORLD, AFTER ALL”

The iconic Sherman brother’s song written for Walt Disney for the 1964 World’s Fair originally served to invoke world unity after the Cuban Missile Crisis. Capital markets have also helped to unite the world, but as we will see “small” may not be the adjective to describe them.

While markets have been an integral part of human society since man left the fields for the city, capital markets took longer to develop. It was not until the early 17th century, when the Dutch East India Company offered shares of its company, that the modern equity markets were born. In the four centuries that have passed, capital markets, both equity and debt markets, have become integral to commerce, industry, politics, and the broad society. Without the flow of capital from those who have it to those who need, it is safe to say technological innovation would have stagnated and global trade would remain in infantile stages. Yet, one only needs to examine their sheer enormity in order to grasp the fundamental importance of capital markets.

The most recognizable market to the average person is, of course, the stock market. Every evening the news recites the equity market performance for the day, and that does not even account for the 24/7 coverage on Bloomberg or CNBC about the next big trade or latest earnings report. But just how big are the total equity markets in the United States and, more importantly, the world?

THE STOCK MARKET

The answer, not surprisingly, is immense. According to the Bloomberg, on July 9, 2012, the total market capitalization of the United States equity markets was 105.8% of the Gross Domestic Product (GDP), or a bit more than $16 trillion. The world equity markets as a whole had a total market capitalization of $47.6 trillion at the same time, making the United States home to approximately a third of all stocks. More telling, however, is the trend in the size of US stock market compared to the rest of the world. Over the last decade or so, the US market has fallen from about a 45% of global markets to its current 33% level.

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Chart source: Bloomberg Professional

Even more illuminating, according to a 2010 study by Russell Investments, “Globalization, equity markets evolution and the perils of home-country bias [sic],” in 1985 the US comprised 66% of global market capitalization. Many reasons can be offered as an explanation for this, but the change is NOT because of a decrease in the value of US based investment markets. On the contrary the US market is much higher today than years ago. The reason is the growth rate of the international markets has been at a much higher rate than the US. The most apparent result involves a decreased role of the US as the world’s sole economic power. In fact, the economies of the entire world’s developed markets have fallen as a share of total market capitalization, and continue to fall, in comparison to the emerging markets (once known as the “third world”).

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Chart source: The Economist, BIS

It is also interesting to compare the growth of emerging economies and the relative market capitalization of those economies. Emerging markets have captivated investors in recent years and with good reason. As the chart from The Economist highlights, emerging economies have become world leaders in several important categories. For instance, they have well over three quarters of the world population and foreign exchange reserves. Additionally, in terms of purchasing-power parity, emerging economies now comprise more than half of global production. At the same time, the emerging countries make up less than a quarter of public-sector debt.

With so many positives driving emerging growth, one area they have lagged behind involves the development of equity markets. According to The Economist, in 2010 broad emerging equity market capitalization was responsible for about just a third of the total global market. When focusing on the four most prevalent emerging economies, the issue becomes more pronounced. Bloomberg’s most recent data shows that total market capitalization of the BRIC countries (Brazil, Russia, India and China) made up just 12.2% of the world. In terms of dollars, those four countries total combined market capitalization is approximately $5.8 trillion, a mere 36% of the United States. While emerging economies will continue to have a growing impact on the world economy, it is reasonable to expect their share of global equity market capitalization to increase as well.

THE DEBT MARKETS

While equity markets serve as the most recognizable capital market, they do not make up the largest position. In fact, debt markets are about twice the size of the world’s stock markets. According to the Bank of International Settlements (BIS), at the end of 2010, total global debt markets had nearly $95 trillion outstanding. It comes as no surprise, therefore, that many institutions and politicians focus on the bond market as a determinant of future economic growth. As Louisiana native James Carville appropriately noted during his time with the Clinton Administration, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Clearly, the bond markets enormous size shapes not only investors sentiment, but also national policy.

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Chart Source: Econideal.com, BIS

 

One other interesting note about the debt markets involves the geographic distribution. Similar to the equity markets, US total debt equals roughly one third of total debt outstanding (about $32.5 trillion). Additionally, the Japanese total debt market comprises another 15% of the world markets. A major difference between stocks and debt involves the concentration of debt securities. While the US has roughly the same percentage, Japan has a much larger concentration than with in equity markets (15% vs. 7%).

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Chart Source: Econideal.com, BIS

Perhaps the largest insight one can gain from the bond market involves the size of debt relative to the size of the economy. To reiterate a point made earlier, many emerging economies have much lower total debt levels than some of their more developed counterparts. For instance, China and Brazil have total debts that are 53% and 72% the size of their economies, respectively. On the other hand, many developed countries have total debt that has exploded well beyond the size of their economies, including the United States and the U.K., which each have Debt/GDP ratios above 200%. While many traditional developed economies will be hindered by high debt service, not only by the government but the consumer and business sectors as well, emerging economies will have more flexibility in capital decision making to continue strong growth. The debt markets play an essential role in determining global growth. At twice the size of equity markets they can, as Carville put it, “intimidate everybody.”

Yet, there is one more market that deserves mention which dwarfs both credit and equity markets.

THE OTHER MARKET

The market for derivatives, that is, a financial instrument that whose value is derived from the price or level of something else, far surpasses any other capital markets. Derivatives come in many varieties. Some derivatives, like stock options or future contracts on commodities, are cleared through a central exchange with standardized contracts regulated by the government. Others, however, such as swaps on interest rates, credit default swaps, foreign exchange derivatives, and other forward contracts can be highly customized, complex, and only started to gain regulatory attention after the financial crisis in 2008. These so called over-the-counter (OTC) derivatives have grown immensely in recent years as many financial and non-financial institutions use them hedge all sorts of risk. At the end of 2011, the BIS estimated the notional amount of OTC derivatives to be a whopping $647 trillion. Considering the Gross World Product (or world GDP) for 2011 was about $70 trillion nominal, the amount of over-the-counter derivatives were more than 900% as much as global output. Granted, most of these contracts were used to hedge other positions and the net amount of derivatives was much smaller than the notional amount, but nonetheless the number is staggering.

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Chart Source: Econideal.com, BIS, Bloomberg Professional

The overwhelming size of the OTC derivatives market does highlight the interconnectedness of modern financial markets. It also illustrates why certain institutions (Bank of America, American International Group (AIG) and Citigroup come to mind) may be considered “too big to fail” as a bankruptcy could cause a domino effect in the world economy. While many investors look to the stock and bond markets, the size and stability of the derivatives markets may be more critical to the long term health of the global economy.

At a certain point, of course, the numbers become so astronomical that they begin to lose meaning and effect. After all, a difference between $47 trillion and $48 trillion does not seem that large. For a bit of perspective of how large a number a trillion is, consider human history. A trillion seconds is equal to roughly 31,700 years. Agricultural societies emerged merely 12,000 years ago, or a few hundred billion seconds ago. In other words, a trillion is a number that is more appropriate for measuring the distance to stars rather than human society.

HOME COUNTRY BIAS

A key takeaway from the exercise of measuring financial markets, other than attempt to grasp their enormity, is that financial markets are far more diverse than just the United States. As we have learned, investors who just have domestic exposure to America are neglecting about two thirds of the world’s stocks and bonds and some of the highest GDP growth rates in the world. While market weight exposure may not be appropriate for most investors, diversification across geographies remains critical to a well-diversified portfolio. 

Investors overweighting portfolio assets to the country they reside is not solely an American phenomenon. In fact, home-country bias, as it is known, exists throughout the world. Many explanations have been offered as reason to home bias such as a perceived informational advantage, ease of investment, and numerous behavioral and psychological conditions. Yet, one thing remains certain, investors tend to favor investing in the country they reside and by doing so they miss out on a tremendous opportunity.

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Chart Source: Wilshire

MARKET CLIMATE

Home country bias and market size remain important as investors build portfolios. Also important for consideration remains the long-term strength of several economies and how they affect markets. Participants in the second quarter of 2012 experienced another “risk-off” period as domestic equity markets had moderate losses (-2.75% for the S&P 500 and -3.47% for small cap stocks) while commodities and international stocks fell considerably more (-6.85% for the MSCI EAFE and -8.78% for the MSCI Emerging Markets). At the same time, investors continued to flock to the perceived safety of US Treasuries with the Long-Term Bond Index returning 10.32% for the quarter, hovering around all-time lows on interest rates.

The first and second quarter illustrate the schizophrenic nature of capital markets in recent years. After a strong first quarter, fears again arose across the Atlantic about the solvency of the certain European nations as well as a potential slowdown in the global economy. After numerous summits, elections, and stop-gap measures, the outlook for the Eurozone remains negative but possibly manageable. The slowdown in emerging economies such as China, hurt commodity prices and investors continue to hang on US employment data in order to determine whether a global recession is imminent or just a false start. At this point, the “fat-tail” risk to the economy remain large, but central bank and government intervention continue to make a “base-case” scenario of slow but steady growth. As always, it is good to stay diversified not only across asset classes, but also geographies. Finally, below is chart of the location of the 500 largest companies in the world. To borrow a phrase from PIMCO’s Bill Gross, the US remains “the cleanest dirt shirt.”

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Chart Source: Eric Platt/Business Insider, Data: Fortune

Above information has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness