Monday, February 21, 2022

International diversification - Depends on the business cycle

There has generally been the view that as global markets have become more globally integrated the gains from international diversification have diminished. The evidence supports higher beta from global integration, but data also suggest that there is still benefit from international diversification. (See "To diversify or not to diversify internationally".) The correlations are highly variable and business cycle dependent. The pairwise correlations will increase during global recessions and then move back to their older long-term relationships when the business cycle stabilizes. Hence, there will be breaks in the correlation relationships through time.

This relationship is consistent with a single global shock having a common effect on all risk equity markets. As the importance of a common shock declines, correlations will fall. 



The correlation across country indices will also be related to the composition of the country index. When there are similar industry weights, there will be higher correlation. Generally, industry correlations are lower than country correlations and will provide greater diversification especially for less integrated EM markets.

While international diversification benefits have declined with market integration there are still opportunities to exploit differences for return and risk management. 

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