Investment Outlook

December 1999

Our December newsletter is not only the last of the year, but in this instance is also the last of the decade, century and millennium. This month, we have decided to devote our market letter to the evolution of stock markets throughout the millennium. Not only is it interesting reading — if we do say so ourselves — but it also provides a context for the changes that are already taking place in the markets today.

Public exchanges, where securities representing ownership interests in various commodities, business ventures, debt instruments and other assets could be bought and sold, date back to the ancient civilizations of the Middle East. In 954, the commercial code established for the city of Amalfi (near Naples) explicitly allowed for the sale of shares in maritime trading ventures, and the sale of those shares to others. Bond trading, where individuals could buy and sell debt instruments (issued primarily by city governments), was quite common in the major Italian cities from around 1100. Regions of Spain were also quite active in trading not too long afterward. The precise date on which the Bolsa de Barcelona was established isn't well known, although the regulations for commerce and trading activity were established in 1271 by Jaime I and the original stock exchange building dates back to 1392. While trading in commodities was fairly common in Barcelona at this time, however, the brokers of the Barcelona exchange didn't start trading equities until the nineteenth century.

For those who wonder why New York (of all places on earth) has become the financial capital of the world, one has to understand how economies evolve. Government policy, trade alliances, industrial development and geography all play a major role, as does the efficiency of a nation's transportation and communications systems at a given point in the process. It is no accident that most of the early centres of commercial activity were typically located along major waterways with access to the oceans, given that they pre-date the railways.

By the early sixteenth century, Antwerp in what is now Belgium had emerged as the commercial hub of Europe. While the city had been a small trading port as far back as the eighth century, it rose to prominence after the English Merchant Adventurers and other traders moved their operations from Brugge — the primary port for English merchants (and which happens to mean 'landing stage' in Old Norse) — in 1446, due to a combination of political disturbances, the decline of the Flemish wool industry, and the silting up of the North Sea inlet, which cut off the city's port access. Antwerp's diamond industry, which began in the 1400s, expanded considerably in the early 1500s with the arrival of exiled Jewish artisans from Portugal. The Duke of Burgundy at the time, Philip the Good (son of John the Fearless), aligned himself with Henry V of England, and during his reign from 1419-65, the territory of his duchy more than doubled through inheritance, treaty, purchase or conquest. Charles the Bold (son of Philip the Good and grandfather of Philip the Handsome) further aligned the region with England through his marriage to King Edward IV's sister, Margaret. His daughter Mary would eventually marry Roman Emperor Maximilian I in 1477, establishing the Austrian Hapsburg family in what is now Belgium and Luxembourg. Antwerp has the distinction of being home to the first stock exchange, established in 1460 under the rule of Philip the Good. Unlike Barcelona which was limited to commodities for most of its existence, the Antwerp exchange actually traded financial securities — primarily bonds at first.

Charles V, son of the king of Castile, Philip I (the Handsome one, not the Good one), encouraged trading of various financial instruments through low taxes and low regulation in the early 1500s. (Incidentally, Philip's grandson, Philip II, married Queen Mary I of England in 1554, and then proposed to her sister — Queen Elizabeth I — after Mary's death in 1558). A new stock exchange was constructed in 1530, where bonds were issued by various governments — including the English Crown and the City of London — and Antwerp became a source of funds for kings throughout Europe. Antwerp was the first exchange that allowed trading of commodities through receipts that outlined the precise quality and quantity of a product being traded, rather than requiring traders to bring their physical product with them to the marketplace — a wise move, considering much of the trade at this time consisted of timber.

While Antwerp was prospering as an economic centre, other port cities were also growing in importance. Hamburg, located on the Elbe River near its mouth on the North Sea, attained commercial importance beginning in the thirteenth century. The city was one of the original members of the Hanseatic League, a group of German and other European towns that entered into agreements to secure mutual protection against pirates and to negotiate reciprocal trading rights. The Hamburg Stock Exchange was established in 1558 to facilitate trade in commodities, and also to provide a place where the coins from the various regions could be exchanged at a specified rate. France, meanwhile, saw the development of its own trading centres, with a stock exchange established in Lyons in 1506. Others followed in Lille and Toulouse. Still other exchanges were popping up in all the major centres, such as Copenhagen, Frankfurt, London, and Berlin.

Antwerp's status as the financial capital of the western world was relatively short-lived, ending abruptly in 1566 with the outbreak of civil war, which ultimately led to the independence of the seven northern provinces — the Union of Utrecht — from Spain in 1581. Amsterdam, located in the north, benefited from the commercial decline of Antwerp and Ghent, and quickly replaced Antwerp as the dominant financial centre of sixteenth century Europe. Amsterdam's status was solidified in 1648 with the signing of the Peace of Westphalia, which ended the Thirty Years War between Catholic and Protestant factions. This treaty gave the United Provinces the right to close the river Scheldt (the main waterway to the North Sea) to navigation, which effectively gave Amsterdam a stranglehold on European commerce at the expense of Antwerp. Amsterdam's stock exchange was established in 1611, and was quite a sophisticated exchange for its time. It provided a marketplace to trade commodities, foreign exchange, equities, insurance and even options and futures contracts. Early trading was dominated, however, by shares of the Dutch East India Company, which was founded in 1602.

While most trading was concentrated in commodities, and to a lesser extent bonds, publicly traded equities came into existence starting in the 1500s with the Muscovy Company, Levant Company, and East India Company, founded in England in 1555, 1571, and 1600 respectively. The business of these companies was to engage in trade with specific regions (typically under monopolistic conditions), and they relied on share capital to finance their expeditions. Shareholders earned a proportionate share of the company's profits and losses. Some of these companies, such as Virginia Company (1606), Massachusetts Bay Company (1629), Royal West Indian Company (1664) and Dutch West India Company (1621) were taken over by governments, but others, such as the Hudson's Bay Company (1670) remain public to this day.

Amsterdam's position as the financial capital of the world lasted only until the end of the 1700s. The Dutch accumulated wealth with the help of government policies that supported free trade, low taxes, protection of property rights and religious tolerance. The Netherlands was one of the only European powers that didn't adhere to the mercantilist doctrine, which (loosely stated) asserts that a country's wealth is determined by its currency holdings — and by extension, a country's growth is achieved by limiting the export of coins and bullion while maximizing the import of currency through trade. Amsterdam's free market policies that supported Dutch commerce, however, were eventually reversed, and an era of expanded government and protectionism took over. Taxes and tariffs began to rise by the end of the 1600s, reducing trade and raising wages and prices. Skilled workers and commerce gradually moved to cities with more favourable business conditions, including Hamburg, Frankfurt, Berlin, Vienna, Paris and London (a historical precedent for Canada's apparent 'brain drain' today, in case the similarity went unnoticed).

The industrial revolution helped establish London as the new financial capital over the other European cities that benefited from Amsterdam's decline, and London occupied this position until the first World War. Between 1760 and 1830, Britain accounted for about two thirds of Europe's industrial output growth, and by 1860, Britain produced half the world's iron and coal. Another distinguishing feature of British commerce at this time is that while European exchanges were being set up as public facilities by governments, British traders were organizing stock exchanges as private enterprises, establishing their own rules for membership and administration. A group of commodity dealers and ship owners met regularly in a London coffee house to negotiate contracts, and in 1744 formed what is now the Baltic Exchange. Similarly, a group of brokers, booted from the Royal Exchange because of their rowdiness, assembled at Jonathan's Coffee House in London to buy and sell shares in joint stock companies, forming in 1773 what is now the London Stock Exchange. These private exchanges popped up all over Britain, and by the 1800s, there were more than twenty independent stock exchanges operating in the country.

The US experience was much the same as in Britain at this time, albeit on a smaller scale. Philadelphia was the financial capital of the US, and in 1790 a group of securities brokers got together to establish the Philadelphia Board of Brokers, which would later become the Philadelphia Stock Exchange. In its initial years, the limited liability company had not really caught on, and most trading was limited to government bonds and bank stocks. The exchange did, however, become instrumental in raising capital to build railways and other public works. The New York Stock Exchange, established two years after Philadelphia by a group of New York securities brokers, was a loosely organized fledging exchange for its first three decades. The completion of the Erie Canal in 1825 — financed by New York State bonds, traded on the New York Stock and Exchange Board — was the turning point that pushed New York ahead of Philadelphia as the commercial capital of the US. The fifth-largest seaport in the US prior to the construction of the canal, New York became the busiest port in the US by 1840, moving more tonnage than Boston, Baltimore and New Orleans combined. Naturally, New York's increased commercial activity led to increased financial activity, with the New York exchange supplanting the Philadelphia exchange as the primary source of equity capital in the US.

London still remained the financial capital of the world throughout the nineteenth century, given Britain's booming industrial economy and its relative stage of economic development. The Civil War in the 1860s didn't help to advance the economic status of the US, as the public debt was driven up to $2.7 billion from just $4 million in 1840. The US was a debtor nation, with capital outflows exceeding inflows right up until 1914. After WWI, however, the global economic landscape changed yet again, with New York coming out as the dominant financial centre. The war was financed in large part by inter-allied debts, with the US holding much of the debt issued by Britain and France, as well as the debt issued by Germany to make reparations to the Allied Nations after the war. US companies supplying munitions and other supplies — such as US Steel, DuPont, General Motors, and Bethlehem Steel — also did very well during the war years. In the space of a few years, the Allied nations went from creditors to debtors while the US went from debtor to one of the largest creditors in the world. The US became an important source of international capital, and From 1918 to 1928, more than 1,700 foreign issuers were offered publicly in the US. Having direct or indirect control over two thirds of the world's petroleum production in the early 1900s also shifted the economic scale in New York's favour.

Canada's forays into the global financial scene have been secondary at best. In 1874, the Montreal Exchange — Canada's primary securities market at the time — listed only 63 issues, and average volume was around 800 shares per day; New York volume, in contrast, exceeded 8,500 shares per day in 1835, and reached the 1 million mark by 1886. While Toronto now dwarfs Montreal in terms of economic significance largely on account of political factors — the TSE accounts for almost 90% of all Canadian equity trading, while the MSE has a 10% market share — it is still a relatively insignificant player in a global context. Only about 4% of the TSE's 1400 issuers are foreign firms, compared to 11% of the NYSE's issuers (representing 33% of NYSE market capitalization at the end of 1998) and 10% of NASDAQ's issuers. In Germany, foreign issuers outnumber domestic issuers by a factor of almost four-to-one.

While politics, war, geography and access to transportation routes were the main factors determining the location of financial centres throughout history, advancements in communications have helped shape the structure of the securities industry both nationally and internationally. Exchanges were situated in virtually every major centre to facilitate trading in local issues or commodities. When what is now the TSE was formed in 1852, there were already 250 highly fragmented stock exchanges operating in North America alone, and by the end of the 1800s, there were more than 1600 commodities exchanges dotted along water ports, seaports and railway lines. The trans-Atlantic cable (1866), stock ticker (1867) and telephone (1876) were all major advancements in communications which rendered many of the smaller exchanges redundant, as proximity to an exchange floor was no longer required to ensure access to trading information. The smaller stock exchanges either disappeared or were merged into regional exchanges, and the 1600 commodities exchanges were reduced to nine within the last century. Within each country, only one exchange has typically survived as the primary financial centre — New York, London, Paris, Frankfurt, Geneva, Tokyo, Bombay and Toronto, for example — with others serving second-tier and/or regional markets.

Computer technology in the twentieth century is the driving factor behind the next stage in stock exchange evolution. NASDAQ, established in 1971 as the world's first electronic stock market, has demonstrated that a stock exchange no longer requires a physical trading floor housed within an imposing neo-Grecian structure to serve its purpose. While NASDAQ uses a different trading method than open outcry exchanges such as the NYSE — NASDAQ is a call market with buy and sell orders posted and matched by a broker, while the NYSE is an auction market with prices determined when the buying and selling brokers meet on a trading floor — other exchanges such as the Paris Bourse and the TSE have demonstrated that computers can be used to execute auction market trades which are traditionally carried out on a trading floor. Trading floors in London, Paris, Tokyo, Singapore, Mexico City, Toronto, and Vancouver (among others) have all been closed as trading has migrated from exchange floors to computer screens.

With trading floors giving way to electronic communications, the need for a physical trading floor is growing less obvious by the day. NASDAQ trading volume is already higher than that of the NYSE, and many prominent companies — such as Microsoft, Intel and Cisco — are opting to remain on NASDAQ rather than list on the more prestigious NYSE. As trading moves off trading floors, it becomes apparent that financial hubs start to lose their relevance. The exchange restructuring currently underway in Canada is indicative of this trend, although in true Canadian fashion it is well behind the international trend towards national consolidation and does not go nearly as far as it could or should (we're still left with three exchanges, which is two more than a country of Canada's size requires). In Australia, the six regional stock exchanges — Sydney, Hobart, Brisbane, Melbourne, Adelaide and Perth — were merged into a single Australian exchange back in 1987. Similar initiatives have been implemented in Germany, Switzerland, and Italy. Within the last few years, not only have boundaries between financial hubs started to erode, but national boundaries are being eroded through cross-border exchange alliances. In 1998, the Copenhagen and Stockholm exchanges formed the NOREX Alliance, which operates a joint trading system and single order book for both exchanges. The intent is to expand this alliance to include the other major Scandinavian exchanges in Helsinki, Oslo and Reykjavik. In July 1998, the London Stock Exchange and Deutsche Börse entered into an agreement to harmonize their senior markets and jointly develop an electronic trading platform for blue chip equities from both exchanges. This past year, eight major European stock exchanges (Amsterdam, Brussels, Frankfurt, Madrid, Milan, Paris, Switzerland and London) have built upon the London-German alliance to develop a harmonized pan-European stock market for blue chip equities. Integration will involve a common rulebook, common trading hours and a common electronic interface — effectively a single exchange.

Given the trend towards cross-border consolidation of equity trading, it is not beyond reason to expect the various US and Canadian (and possibly Mexican) exchanges to eventually form a North American Stock Exchange. There will undoubtedly be some resistance — New York probably doesn't want to be associated with junior VSE mining companies, and it is fairly certain that some Canadian trade groups will deem such as move as the selling out of Canada to US business interests — but when a multinational has the option of trading on a single US exchange or on a unified European exchange with similar volume (if not higher), the choice may not be as clear as it used to be. With increasing competition from both North American and international exchanges, the need for cross-border exchange consolidation may come sooner than many people think.

On a final note along the lines of technology-driven evolution, this will be the last issue of our Investment Outlook to be mailed with monthly statements. Our newsletters will instead be made available only on our website at www.goldencapital.com. For those who would like an email reminder when a new issue is posted, please visit the research section of our site and submit a registration form.

In closing, we would like to take this opportunity to thank all of our clients for their continued patronage, and extend our best wishes for a safe and happy holiday season and a prosperous new year.