Buttonwood: All in the same boat

The Economist

DIVERSIFICATION is supposed to be one of the rare free lunches in finance. Spread your assets geographically (or by asset class) and the chances are that your investments will not rise and fall together. Investors should be able to get the same reward with less risk.

But, as the chart shows, global stockmarkets have steadily become more correlated over the past few decades. Wake to the financial headlines on any given morning and you will find that a sell-off in Asia has spread to Europe and that, all too often, both continents are reacting to a late plunge on Wall Street. It is rare for individual markets to go against the trend.

As a consequence, the fundamentals of individual economies can be less important to their short-term equity performance than investors might expect. Emerging markets have better growth prospects and sounder public finances than their developed-world counterparts. But those Western investors who have sought to take advantage of these differences can end up feeling disappointed. At the end of August, the MSCI emerging-markets index was down by 10.3% in dollar terms since the start of the year. The developed-world index was down by 5.4% over the same period.

Globalisation is partly to blame. The volume of world trade has risen in every year bar one (2009) over the past decade and now represents 29.7% of GDP, up from 23.8% in 2001. Many developed countries are counting on a surge in exports to boost their own sluggish domestic economies.

It is not just a question of trade. Many of the world’s leading companies are multinationals with operations scattered throughout the world. The recent poor growth record of the developed world means that many Western firms are pinning their expansion hopes on Asia or Latin America. By the same token emerging-market exporters like Samsung or Petrobras need consumers in Europe and America to keep spending. Analysis by BNP Paribas finds, for example, that more than 20% of the revenues of constituent companies of the Dow Jones Industrial Average comes from emerging markets; 36% of the revenues of FTSE 100 companies is generated in North America; and almost 14% of the revenues of listed Korean companies stems from Europe.

The Federal Reserve may also be playing its part. Investors have been relying on the Fed not just to revive the American economy but to prop up asset markets through its bouts of quantitative easing (QE). Since the dollar is still the global reserve currency, Fed decisions affect investors all round the world. When Ben Bernanke hinted at a second round of QE in August 2011, the resulting rally was global, not just confined to Wall Street. Fund managers around the world are hoping he opts for a third round.

Another crucial factor may be the existence of large fund-management firms, whose portfolios are diversified across the globe. A new academic paper* looks at how these funds may act to transmit shocks from one market to another.

Fund managers do not make their buy-and-sell decisions based on the economic fundamentals alone. They have to adjust their portfolios as clients send them more money or ask to redeem their holdings. If retail investors in Iowa want their money back, fund managers have to sell something and that may mean Brazilian or Chinese equities.

Those Iowans may well be reacting to domestic news, such as the debt-ceiling crisis in late July or Standard & Poor’s downgrade of America’s credit rating. But the result of their actions is that global markets fall in unison. The authors describe the process in this way: “Global funds substantially alter portfolio allocations in emerging markets in response to funding shocks from their investor base.” They found that those emerging markets that were most exposed to these global funds were both more correlated with one another, and more correlated with the developed markets in which the funds are domiciled.

There is an irony at work here. Global funds are invested in Brazil and China because investors want a diversified portfolio. But the very act of diversification means that these markets become more tied to the developed world and the rewards of diversification are accordingly reduced. It is not really diversification when everyone has the same idea.

* “Asset Fire Sales and Purchases and the International Transmission of Funding Shocks”, by Chotibhak Jotikasthira and Christian Lundblad of the University of North Carolina, and Tarun Ramadorai of the Said Business School in Oxford, August 2011