Advanced economies face slow growth, tighter regulation and high debt, so indices that focus on GDP, rather than market capitalisation, would encourage investment in low-debt countries.
GDP-weighting also produces a composition that is more forward-looking, providing a better reflection of where capital markets and investor portfolios will be in coming years. Traditional patterns of global indebtedness are being reversed, as industrialised countries expand government debt issuance at an accelerated pace while many emerging economies have become large-scale creditors to the rest of the world.
Another disadvantage of market capitalisation-weighted indices is that they assign progressively greater weight to securities as they go up in price. GDP-weighted indices not only avoid this pitfall but also have the potential to benefit from counter-cyclical rebalancing, since bond prices tend to move inversely to GDP growth over the business cycle – rising as economic growth slows, and falling as economic growth accelerates. A GDP-weighted index that increases the relative weight of countries in the expansion phase of the business cycle and reduces the relative weight of countries in the contraction phase helps embed a “buy low, sell high” bias.
The economic environment will be characterised by lower growth in the developed economies, higher growth in the emerging economies, and greater government intervention and regulation. Historical models and econometric forecasting based on the experience of several decades may not only be useless, but counterproductive. It is time we reassess how we evaluate sovereign credit risk.