(03 January 2020)DAILY MARKET BRIEF 2:What to expect from global diversification?

The issue boils down to correlations between US and international equity returns differing depending on the time horizon considered. As a result, average correlations over time, which are typically used to demonstrate diversification benefits, are a misleading measure of what investors should expect.

This limitation is most glaring during risk-off periods when equity markets tend to correct together. In these periods, lasting weeks or months, declines in investor risk sentiment drive down the valuations of risk assets, leading to drawdown correlations close to one. Consequently, global equity portfolios usually have similar or slightly larger drawdowns than the S&P 500 during these periods.

Global diversification may not reduce portfolio drawdowns over short horizons, but the benefits are there over the long term. The swings in global risk sentiment that lead to simultaneous drawdowns are temporary. Once these episodes pass the primary driver of equity returns are the economic fundamentals supporting earnings growth. These differ at a country or regional level at horizons of 1-2 years and the differences can be even more stark over a full decade.

The take-away is that investors with multi-decade planning horizons should benefit more from a globally diversified equity portfolio, as the benefits are most pronounced over long horizons, not short ones. For these investors being exposed to a long US bear market, or one that significantly underperforms its global peers for years, is far more damaging to their wealth than short-term drawdowns.

The benefits of global diversification have changed the past few decades and could evolve in the next one or two. The correlation between US and international equities has increased since the early 1990s, a consequence of the globalization of trade and financial markets. This has reduced, but not eliminated, the benefits of global diversification. But now globalization and the free flow of capital are slowing and may partly reverse as regions start to de-couple. Specifically, the US and China may go down separate paths with distinct spheres of influence that make the world less unipolar and correlated. That would argue for more global diversification in your equity portfolio, not less.

By UBS