We all know the geographic domicile of an equity index bears little resemblance to the geographic spread of its underlying revenues. 
If you invest 100 per cent of your portfolio in the FTSE 100 that does not mean you are investing in 100 companies that sell 100 per cent of their wares to UK firms and households - globalisation put paid to that.
It is for this reason that UK GDP growth has little correlation to FTSE 100 earnings, let alone FTSE 100 stock prices.
This poses problems for asset allocation and portfolio construction. Too often, investors conflate the macro and the revenue outlook in a manner that doesn’t quite reflect reality.
You might be very bearish on the prospects for the eurozone economy, but if 50 per cent of earnings come from outside the region eurozone equities might - on a revenue basis alone - still be an optimal addition to multi-asset portfolios.
Contrary to popular — or at least some professional — wisdom, there is actually quite a strong correlation between GDP growth and sales or EPS (earnings per share) growth at the global level (see chart below).
Source: Rathbones
At a country or index level, it’s a matter of aggregation. It’s untangling these revenues into the regions where they were actually made that can be tricky.
To help us solve the problem, we have made use of a new database from MSCI via Thomson Reuters. The database holds the revenues earned by thousands of companies around the world, split by the countries in which those revenues originate.
There is no global standard for reporting the geographic split of company sales, so compiling such a database is a rather monumental task. That said, the data still requires sense-checking and translating into common currencies for aggregation purposes.
We used this information to estimate how the revenues underlying the six major regional equity indices (UK, North America, Japan, Europe ex UK, Asia ex Japan and Latin America) are actually spread around those same six regions. We estimated the revenue exposure of an index from its 200 largest firms (300 in the US), which represent around 90% of the indices’ market cap.
As our second chart below shows, UK equities have the most geographically diversified revenue streams.
Source: Rathbones
Of the four developed markets, it is the most exposed to emerging markets, with approximately a quarter of all sales originating in Asia ex Japan and Latin America. European equities are also quite diversified with only 50 per cent of revenues stemming from the continent. The other regions are all heavily weighted to their home markets.
A useful starting point
With this information, we can observe a far stronger relationship between GDP and company revenues. A composite of global GDP weighted by the sales exposure of the respective regions explains between 60 per cent and 80 per cent of the variation in sales over the past 12 years (which is as far back as the revenue data extend).
Discrepancies still remain, largely because the sectoral breakdown of the GDP composites won’t match perfectly with the sectoral breakdown of the indices, but the two are now much better aligned.
With the connection re-established, we can employ projections of potential GDP growth (based on stable trends in the workforce, the stock of capital and productivity) to serve as a guide to the revenue growth of regional equities over the long term. Of course, this is going to be a very rough guide, and it abstracts from the business cycle too (as we should when thinking about the long term).
Revenue growth is only one component of equity returns, but it is a useful starting point when setting strategic asset allocations with time horizons of more than 10 years.
Ed Smith is an asset allocation strategist at Rathbones. The views expressed above are his own and should not be taken as investment advice.