The investment industry has a bad habit of talking about ‘UK stocks’ or ‘US equities.’ Like many bad habits, it started for understandable reasons. 
When public companies first came into existence, they did so to raise money from local investors, in order to carry out their business. Stock exchanges sprang up as convenient places for these investors to trade their shares and for companies to issue new ones.
Up until the early 20th century, the link between the stock markets and economies therefore made sense. While these companies’ commercial activities were often global, the profits came back to the home country – where they were spent, or taxed, or reinvested. If the shareholders were doing well, so was the economy (most of the time).
For most major benchmarks, that is no longer the case. The link between geography and economy has been almost completely severed.
Modern markets
Today, stock markets look very different, for two main reasons. The older companies have outgrown their domestic roots, while many newer businesses ignore geography altogether.
The FTSE 100, for example, includes lots of companies that started small and local, but for which the UK is now just a handy place to keep a head office. Drinks brand Diageo makes roughly 5 per cent of its revenue from the UK. Royal Dutch Shell and BP make far more money from Asia than from the UK – as does HSBC. Even the London Stock Exchange Group makes only about half of its money in the UK!
And for newer large companies, the country or city where they choose to list their shares often has nothing to do with their business models or where they make their money. It tends to be largely a matter of tax optimisation, prestige and availability of global investors.
Take Aramco, the huge Saudi Arabian state oil company, which was at one point looking to list in either New York, London or Hong Kong. Or Alibaba – the all-conquering Chinese consumer/technology company which is listed in New York, alongside three others in the list of the largest 10 Chinese businesses.
Focus on sector exposures
Many investors are making the wrong connections. They focus on the prospects for a certain economy and then talk about whether to invest or not in its market. They suggest that Japanese equities might do well thanks to a new prime minister, or the inflation outlook, or fiscal policy.
We believe that’s wrong. The differences in performance between countries’ equity markets largely comes down to sector exposures. Whether as a result of historical accident, different listing rules, or tax treatments, every equity market is different, tending to be dominated by one or two large sectors.
The US, for example, is dominated by technology stocks due to the magnetic draw of Silicon Valley and the promise of easy financing. But those companies – Apple, Facebook, Google and so on – have a reach that far exceeds the US. To like the US market you have to like the prospects for technology companies.
In Japan, over one-fifth of the benchmark is industrial companies, so to have a view on Japan’s market, you need to have a view on the global demand for manufactured goods. But Japan has no real energy companies to speak of, so the oil price shouldn’t really enter the equation.
Likewise, the UK is global banks and global oil companies, with no technology worth mentioning. Emerging markets have lots of financial sector exposure alongside a large consumer sector, but precious little in the way of industrials or healthcare.
Digging deeper
The financial industry is still working with outdated tools. Investors aren’t looking at sectors, so providers don’t create products. BlackRock has $50bn in its US equity market ETF and less than $5bn across all 12 of its US sector ETFs. No UK iShares sector product even exists.
Looking at the performance of sectors over the whole of last year helps to make the point. In the second column of the table below, we’ve ranked the performance of global sectors, and then slotted in the S&P 500 and FTSE 100 index.
In the third and fourth columns, you can see the sector allocations in the two indices at the beginning of 2020. The S&P 500 had one-third of its weight allocated to the two best performing sectors over the following 12 months, whereas the FTSE 100 had under 10 per cent. Worse, at the other end of the scale, the FTSE 100 had three times as much in the terribly performing energy sector than the S&P 500.
Source: Bloomberg Finance L.P. Total return performance from 31 Dec 2019 to 31 Dec 2020. Sectors weights correct as at 1 Jan 2020
This is nothing to do with national differences, but everything to do with the activities of the businesses in the indices.
So rather than looking at geographies, we would urge investors to focus on the businesses which make up the index. There’s no perfect question to ask yourself – but they should encompass the nitty gritty of what may impact a company’s prospects. For example: will demand for commodities such as copper be higher or lower than last year; will the oil price rise or fall; or will computing power demand rise by as much as last year?
Because the most important driver of stock market returns is not the international dialling code. The dominant factor in a developed stock market is the blend of industries which it contains – what a company does is far more powerful and important than where it is based.
Ben Kumar is senior investment strategist at 7IM. The views expressed above are his own and should not be taken as investment advice.