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Rekenthaler Report

Honesty Still Counts for Stock Market Performance

Good governments make for good equity returns.

Five Years Ago
In summer 2013, I wrote “Honesty Did Pay.”

That article pointed out that while portfolio managers typically cited either growth opportunities or cheap prices as reasons for buying a country’s equities, there were other important factors. Examples included political stability, how shareholders were treated, and currency strength. Presumably, also, clean governance. One would think that honest officials are good for business.

So, I tested that thesis. At the time, 21 of Morgan Stanley Capital International’s single-country indexes had 20-year histories. I took them all, comparing their total-return rankings to their Transparency International ranking. (Transparency International is an organization that assesses each country’s level of public-sector probity--or, to adopt the reverse view, each country’s level of corruption).

(The returns were calculated in U.S. dollar terms. We can argue whether that is the best approach or whether measuring local results is superior. Each choice can be defended. But either way, the conclusions are broadly similar, as the currency effects are variable. Their winds do not push consistently in a single direction.)

I then charted those rankings in a scatterplot, with 1 representing the top ranking (that is, the highest return or the greatest public-sector honesty) and 21 being the lowest. To align the graph with visual custom, whereby the best outcomes appear in the upper right, I organized the axes so that the numbers counted down. But never mind that. The point is, the good results appear in the upper right and the bad in the lower left.

Bingo! Grand slam! Cliché, of choice! The picture was wonderfully clear. The five highest-returning countries were a Who’s Who of governance: Sweden, Denmark, Finland, Switzerland, and Norway. Meanwhile, the five lowest returners included three of the more corrupt: Italy, Austria, and Ireland. (Note: These were far from the bottom of Transparency International’s barrel. The biggest failures--for example, Somalia and North Korea--don’t have stock markets in the first place.)

Fast Forward
This column updates that study to see if the relationship continued over the ensuing five years. It did. The pattern weakened, particularly with the biggest nations, but its overall direction remained intact. Stock market returns continued to be positively correlated with a country’s trustworthiness.

Now the details.

For this inquiry, I expanded the list to the 40 largest global stock markets. Performance is from August 2013 through July 2018. Once again, Transparency International provided the corruption data. As the stock market list and transparency rankings each came from 2013, they weren’t biased by the future results. They reflect what investors knew at the time.

The correlation between the corruption and total-return ranks was 0.37. That is somewhat lower than with the 2013 chart, making the regression line flatter, but it nonetheless points northeast. The Netherlands, Hong Kong, Belgium, Japan, and United States all placed among the top 12 for both governance and returns. Conversely, Nigeria, Russia, Indonesia, the Philippines, Mexico, and Colombia landed in the bottom 12 on both measures.

To view the evidence another way--of the 10 countries that scored in the bottom quartile for returns, nine had above-average levels of corruption. The only exception was Portugal, and, at 19th place for governance, it was barely in the top half.

This, it must be confessed, is the equally weighted conclusion. The market-capitalization evidence is less convincing because of the two giant exceptions of India and China. They enjoyed, respectively, the third- and fourth-highest returns while scoring relatively poorly for honesty. And that was no five-year fluke. Their longer-term results are also strong.

So perhaps, this column’s headline should be modified: “Honesty Still Counts for Stock Market Performance, Unless the Country Possesses an Ancient Culture and Contains More Than 1 Billion People.” For the most part, stocks from countries that have grasping public sectors aren’t much good. However, those from the very old, very large societies of China and India have behaved differently.

About Risk
Thus far, I have discussed only returns. Risk matters, too. There, the evidence is particularly compelling. As shown below, the correlation between a stock market’s five-year standard deviation and the honesty of its public sector was high indeed, at 0.64. To a first approximation of the truth, markets from the countries with good governance were relatively stable and those from other countries were not.

(In this case, I grant, the decision to measure all returns in dollar terms does affect the outcome, as stock returns from currencies that are pegged to the U.S. dollar figure to be more stable than those that are not. However, as Japan and the United Kingdom measured as among the least risky bourses, with neither the yen nor pound being tethered to the dollar, the currency effect was not overwhelming.)

Developed vs. Emerging Markets
It will be protested that this column is little more than a treatise on the behavior of developed versus emerging markets, disguised as a commentary on corporate governance. There is truth to the assertion. Almost all the markets with the better Transparency International scores are regarded as developed and those with the weaker scores as emerging.

But which came first, the chicken or egg? Qatar and the United Arab Emirates have higher per-capital income and larger economies than Denmark and Hong Kong. However, the first two are classified as emerging and the latter two as developed--in no small part because of the state of their public sectors. Therefore, it could just as well be said that distinctions in developed versus emerging markets are commentaries on clean governance in disguise.

Also, the pattern holds within each group. Nearly all the countries in the original 2013 study were developed, yet there was a correlation between stock market performance and (lack of) corruption. Similarly, aside from the glaring exceptions of India and Turkey, within this year’s emerging-markets group, those countries with relatively modest levels of corruption mostly outdid those with higher levels.

This is not to argue that corruption measures, such as Transparency International’s, should underlie an investor’s country allocation. That would be claiming too much. However, I do suggest that the topic of governance is underappreciated. Investors now ask, “How quickly will this company grow?” They should supplement that question with, “And how much of its potential profits will be diverted to government officials?”

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.