The correlation within the financial cycle - Not good for those looking for international diversification

One of the core strategies for portfolio diversification is increasing exposure to international stocks and bonds. This risk reduction strategy is easy to achieve, yet the value of this asset class diversification has diminished over the last few years. The financial cycle has more commonality as measured through times series analysis, and it is harder to achieve the diversification benefits desired if there are more correlated financial cycles.

There are a host of reason for this increase in financial cycle correlation, but no one explanation can do the job even after accounting for the Financial Crisis. There is a real economic reason for the higher financial correlation; bilateral GDP's are also increasing, but that does not nearly explain the more explosive increase in equity price bilateral correlations. There are structural reasons for bilateral correlation changes given the lower capital control, increased capital flows, and greater economic integration. However, most important may be the tighter financial links across countries between US monetary policy and global risk appetites.

The paper, "Global Financial Cycles and Risk Premiums", provides a wealth of empirical information on this important topic. It shows a clear change in the response equity premiums to an interest rate shock over the last few decades.

If this work is true, we should see equity price declines with the Fed's higher rate policy. Holding risky asset abroad will not provide safety as global risk appetites change with monetary policy tightening. Investors will have to look harder for diversification in their portfolios.

Given less diversification from equity risk premiums, investors will have to look to alternative risk premium to gain diversification based on factors less sensitive to risk appetites. This may not be easy since attitudes to risk pervade all risk premiums.,