Why Global Equity Exposure Remains Important in Today’s Markets
By Michelle Black
Capital Group Private Client Services Senior Vice President, Wealth Advisory
By Sunder Ramkumar
Capital Group Senior Vice Present, Client Analytics
Whether it’s the U.S.-China tiff, proposed restructuring of the North American Free Trade Agreement or budding trade friction elsewhere in the world, concerns about protectionism have spurred market volatility and raised doubts about the future of globalization.
The reality is that years of integration have boosted trade and capital flows across economies, resulting in global financial markets that are highly correlated with one another. In other words, markets increasingly tend to move together in unison, rather than in different directions when economic or market events occur. For proof, look no further than the bouts of market volatility this year, as markets from the U.S. to Asia have sold off in tandem.
This raises several questions: Why are correlations so high? Should investors care? And what can they do in response?
Trade policies have reshaped global commerce.
Three primary factors have pushed up correlations among markets: trade policies, capital flows and the growth of multinational corporations.
Policy changes designed to foster global integration have played a major role in rising correlations. This global connectedness can be traced to the General Agreement on Trade and Tariffs that kicked off in 1986 and culminated in the creation of the World Trade Organization in 1995.
There were three other major trade agreements during this period, including the North American Free Trade Agreement (NAFTA) between the U.S. and Canada in 1988, which expanded to include Mexico in 1994. These developments had a profound impact on global trade.
Academic research shows that the number of preferential trade agreements rose from 42 in 1990 to almost 280 by 2016, and average tariffs decreased from 22% to less than 10%. Global commerce surged as trade barriers decreased, with the ratio of global trade to GDP climbing more than 50% over that period and sharply accelerating in the 1990s.
A wave of financial liberalization also increased cross-border capital flows. Capital controls fell in the developed world and a number of stock markets opened in emerging markets. Foreign direct investment — controlling stakes with greater than 10% ownership in foreign entities — grew more than 250% from 1990 to 2016 as a percentage of GDP.
As depicted in the chart above, correlations began to rise in the mid-1990s and have stayed consistently elevated in both normal and stressed financial markets; this includes the dot-com bust in the early 2000s and the global financial crisis in 2008.
Finally, multinational corporations have emerged as a significant force and a powerful vested interest in support of globalization.
The United Nations Conference on Trade and Development estimated in a 2017 report that the total assets of multinational corporations' foreign affiliates surged from $4.6 trillion to $113 trillion between 1990 and 2016. These foreign affiliates employed 82 million people and generated roughly 11% of global GDP.
Globalization is likely to remain potent.
Despite protectionist rhetoric, the depth of global financial linkages and the dominance of multinational companies today suggest that globalization is unlikely to reverse substantially in the near term.
International investing has traditionally been a source of diversification and risk mitigation for U.S. investors. That’s no longer the case. Our research suggests that the automatic risk reduction from including international equities within portfolios has greatly weakened as market correlations have increased.
The chart below shows that historically U.S. investors could reduce risk by allocating a slice of their portfolio to companies domiciled outside the U.S.
For example, a portfolio with 40% in international stocks had approximately 1.5% lower volatility than an all U.S.-equity portfolio, as well as lower losses in down months. However, such diversification has flattened significantly over the last 20 years.
Even so, this does not mean that investors should ignore international markets. Rather, investors may need to look at international investing differently.
First, the key benefit of international equities today is an expanded opportunity set. More than half the market capitalization of listed companies is outside the U.S. While it may seem as if the U.S. has a diversified mix of sectors, American companies make up less than half of the global market capitalization in sectors such as telecommunication services, materials and financials.
Second, flexibility to invest across borders can lead to better results, as the chart below shows. Our research finds that the top quartile global funds tracked by Morningstar exceeded the average annualized return of the S&P 500 by 2.9 percentage points, and the MSCI World Index by 4 percentage points for the 20-year period ended December 31, 2017.
Not only that, they also matched (and slightly outpaced) the returns of the top quartile U.S.-equity funds, despite significant headwinds to international equities in aggregate, demonstrating that above-average stock pickers who use a bottom-up style may be able to capture the value of global opportunities.
Michelle Black has 22 years of investment experience, 16 with Capital. She leads the Capital Group Private Client Services Wealth Advisory Group, which helps clients build portfolios as well as other financial planning strategies.
Sunder Ramkumar has 13 years of investment experience, two with Capital Group. He researches asset allocation and investment strategies. He holds an MS in management science and engineering from Stanford.
Posted on June 13, 2018.