Lu Liu.
Equity prices reflect the market value of public companies, making them an important indicator of the economy. In practice, stocks by firms listed on the local stock exchange serve as the ‘domestic’ equity benchmark but this might be misleading as an indicator of the national economy: stock markets track the performance of individual firms, including their international business. This makes it particularly challenging to extract a signal for the UK economy from UK equity prices, as the universe of UK-listed firms tends to be very global – for instance, around 2/3 of sales represented on the FTSE All-Share are generated abroad. So for a better read of the UK economy, I’ll look at a subset of more UK-focused stocks and other more domestically-focused UK equity indices.
Global markets, global cash flows?
The FTSE All-Share as the typical UK equity benchmark is highly correlated with other international equity prices. This is in part due to common global drivers of discount rates and greater financial market integration creating a global investor base. This means financial cycles seem to have become more synchronised globally. But so have real business cycles as companies have increased their international economic linkages through trade and global expansion. To illustrate this, Figure 1 tracks the share of sales generated abroad by the average listed UK corporate over time, reflecting both international operations, such as revenues from a factory or subsidiary abroad, as well as exports. This share has generally increased over time for most sectors. This means that it’s become harder to separate out the signal from equities for the UK domestic economy – which is what I’m interested in – from other global (financial and real) factors.
Figure 1: Share of international sales over time, average listed UK non-financial corporation by sector, 1987-2015
This is particularly an issue for the UK: UK equity indices stand out against their international peers in terms of their international cash flow base. Around 2/3 of sales of companies that are listed on the FTSE All-Share are now generated abroad, based on estimates from firm-level company accounts data. Even for the FTSE 250, which is thought to be a relatively more domestic index, around 1/2 of sales are still generated abroad. For companies listed on the S&P 500 this figure is about 1/3, and just under 1/2 for companies listed on the Euro Stoxx. So UK equities are particularly international compared to other benchmark equity indices.
These issues are not just relevant for extracting a signal for the UK economy but also open research questions such as the link between asset prices and macroeconomic fundamentals.
Sorting FTSE All-Share constituents into UK-focused and international baskets
How do we get a better signal about the domestic outlook from UK equities, given their international cash flow base? One obvious approach is to look at past stock price correlations with UK business cycle indicators, to get a sense of which stocks are most correlated with the UK economy – but these correlations may vary quite strongly over time. A perhaps more robust and fundamentals-driven way is to sort firms into how domestically focused their underlying businesses are. This requires a deeper dive into firm-level data: I standardise and split each firm’s sales into world regions (covering about 95% of total sales), which allows me to sort companies listed on the FTSE based on their regional activity and to form bespoke portfolios within the FTSE All-Share, including a more UK-focused index. I define companies with greater than 70% of their sales generated in the UK as UK-focused firms, and I create separate sub-indices for firms with more than 40% of their sales generated in other regions: US, euro area, and rest-of-world focused firms, respectively. Companies included in the UK-focused index have a cash flow base that should be more closely linked to the UK economy, and the index should be more correlated with domestic macroeconomic indicators.
A range of UK equity indices
Figure 2 shows different UK equity indices compared to the FTSE All-Share (shown in the black line). Over the post-crisis window, more domestically-focused indices such as the FTSE 250 (in green) and UK-focused index (dark blue) outperformed the more international FTSE All-Share and FTSE 100 (orange). The UK-focused index fell also more sharply following the EU referendum. The recent relative underperformance is in part driven by the depreciation of sterling, which raises sterling-denominated earnings from abroad and hence benefits more international indices such as the FTSE 100 or FTSE All-Share. So overall, there has been some substantial divergence between more domestically-focused indices and more international UK equity indices.
Figure 2: UK equity indices, 2009-latest
(a) Companies are categorised using annual financial accounts data on their geographic revenue breakdown and indices are rebalanced over time.
(b) Companies that generate at least 70% of their revenues in the United Kingdom.
Source: ThompsonReuters Worldscope, Bank calculations
There are a few things to bear in mind with this sorting approach. Since equity prices are linked to total expected cash flows of a firm (i.e. claims to domestic cash flows are not traded separately), I have to categorise each firm as a whole, even though only a part of its operations may reflect UK activity. However, the higher the share of sales in the UK, the more likely it is that the company’s prospects should be related to UK economic activity. I face a trade-off here, as I want to maximise the signal about the UK, but don’t want to apply too high a threshold to skew the representativeness of the sample. As can be seen from Figure 3, using the 70% cut-off for UK-focused equities, there is still a higher representation of sectors that are naturally more domestically-focused, such as construction-related businesses and consumer services, which make up around 1/5 and 1/4 respectively as a proportion of total market capitalisation. But I manage to capture some manufacturing firms, which make up around 1/10 of the basket, despite their generally more international focus. The threshold does exclude banks. This means that it remains useful to look at a range of measures, for instance sectoral indices for banks, or other relatively domestically-focused indices such as the FTSE 250, to extract information about the UK economy as a whole.
Figure 3: Sectoral composition of UK-focused equity index, by share of market capitalisation
As at July 2016.
*Does not include banks.
Where is home to you…
Does sorting firms by regional activity capture the respective “domestic” fundamentals? UK-focused firms’ performance should be more closely related to the UK domestic economy. Likewise, I can sort the more internationally-focused firms into sub-indices by regional activity, as a cross-check. Figure 4 shows these sub-indices as dotted lines, and compares them to other global equity indices (all converted to £). Over that period, US and RoW-focused baskets were quite highly correlated to the S&P 500 and MSCI EM index in £ terms, respectively. This could come from the exchange rate translation of cash flows earned by US-focused UK firms in dollars, which are converted back into sterling for the index. But that doesn’t seem to be the main driver of the correlation. That leaves us with some evidence that the performance of US-focused UK equities is related to the US economic outlook – since the S&P 500 itself is quite “domestically-focused”. This pattern doesn’t seem to apply as much for euro area-focused UK equities. Part of this could be related to how comparable companies in these baskets are, for instance in terms of sectors. In addition, the Euro Stoxx has a more international sales base than the S&P 500, so its performance may be less linked to the economic outlook for the euro area.
Figure 4: Global equity indices (in £) and international components of the FTSE All-Share, 2009-2015
(a) Companies are categorised using annual financial accounts data on their geographic revenue breakdown and indices are rebalanced over time.
(b) Companies that generate 40% or more of their revenues in the United States, euro area or rest of the world.
Source: ThompsonReuters Worldscope, Bank calculations
UK-focused equities – A more ‘local’ UK stock index?
The heterogeneity within the FTSE is also reflected in stock return correlations of the UK-focused and other international baskets. Figure 5 illustrates the correlation coefficients between different equity index pairs as a heat map. Global benchmark equities are highly correlated with each other, as shown by the relatively “hot” (or red shaded) first square of the five global benchmarks. In fact, the FTSE All-Share is most closely correlated to the MSCI World in £ terms over this period, possibly reflecting the international nature and cash flow base of the index. In contrast, the UK-focused equity index sticks out as being least correlated with these global benchmarks, including the FTSE All-Share as a whole, and almost uncorrelated with the MSCI EM. And it also appears most correlated to a domestic activity indicator such as the UK Markit/CIPS composite index of production, at monthly frequency. So it could be understood as a more ‘local’ UK stock index.
Of course these correlations change over time. But the lower correlation with other global equity indices over this period could be tentative evidence that the UK-focused equity basket is less affected by global factors, and may contain a stronger signal about the domestic economy than other commonly used UK equity benchmarks, making it a useful additional tool for policy makers and practitioners. Together with other UK equity indices, it provides a better read of the UK economy than the internationally diversified FTSE All-Share benchmark alone. Hence sorting stocks by firm-level fundamentals can recover some of the real-financial links between UK equities and the domestic economy.
Figure 5: Correlation heat map of global equity prices and UK geographic baskets, 2000-2015
Correlation coefficient based on daily data, except UK CIPS/Markit composite index (using monthly averages)
Source: ThompsonReuters Worldscope, CIPS/Markit, Bank calculations
This post was written whilst Lu was working in the Bank’s Macrofinancial Analysis Division.
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