The degree to which the world’s stock markets move in sync with each other has fallen to the lowest level in 20 years.
The lower correlation enhances the risk-reducing benefits of diversification.
This may be especially good news right now since stocks may be due for a pullback.
The bulls aren’t running in a herd. Bull markets can be found in the stocks of countries around the world, but their movements are less correlated with each other than they have been in the past 20 years. The change brings the return of an important diversification benefit for holders of globally diversified portfolios.
Zigs and Zags
Traditionally, the logic behind including international stocks in a portfolio was not just for their potential returns, but also for the benefit of risk-reducing diversification. The thinking is that when one market would zig, another would zag, resulting in a smoother path to financial goals.
Sadly, for much of the 2000s, global diversification had all but faded away as stocks around the world increasingly moved in sync with each other. There were a couple of key reasons for this. First, global stocks were collectively impacted by the U.S. focused technology and housing bubbles. Second, the increasingly integrated global economy boosted international sales to exceed domestic sales for the global companies in the MSCI All Country World Index. These factors contributed to inevitably higher correlations across stock markets: when one market would zig, the others would zig too.
Return to normal?
Fortunately for investors, diversification has made a comeback. Measured statistically, the correlation between stock markets of the Group of 20 nations (plus Spain, which is a quasi-member), that together make up 80% of world GDP, peaked in 2011 and has subsequently fallen in recent years to levels not seen since 1997, a time before the tech bubble had fully inflated.
This decline in correlation has taken place despite broad economic growth in these economies and in the trade among them. On the chart below, it almost appears to be a return to “normal” for correlation as it moves back to the average level that prevailed for more than 25 years through the 1970s, 1980s, and for much of the 1990s prior to the bubbles in tech and housing.
Global stock market correlation slides to 20 year lows
*Daily one-year rolling correlation of one month percent change in MSCI indexes for countries in G20 and Spain. Source: Charles Schwab, Factset data as of 7/11/2017.
If sustained, this lower correlation—and the risk diversification it suggests as markets move more independently of each other—is particularly good news right now. Stocks may be overdue for a pullback. For the past 20 years, global stocks have not gone a calendar year without at a 30-day pullback of at least 5%, as you can see in the chart below. But, so far in 2017, the biggest 30-day pullback was less than 1%.
Are stocks due for a pullback of 5% or more in the second half of 2017?
Source: Charles Schwab, Bloomberg data as of 7/21/2017.
The potential for stock market volatility may be heightened; the third quarter has historically exhibited higher volatility. The schedule for this week includes the peak for Q2 earnings reports, a Fed meeting, and key economic data. The month ahead includes events such as the start of the Atlantic hurricane season (which could impact oil prices), the first in a series of NAFTA trade meetings, and the threat of a missile launch by North Korea. It’s possible these, or as yet unknown, events could trigger a pullback for stocks.
Will the decline in correlation to a 20 year low persist or will global stock markets all slide together? It is possible the correlation could bounce higher in a pullback, but the downward trend in recent years suggests that correlations may still remain lower than in the 2000s. The driver of lower correlations among countries seems to be lower correlations among sectors that drive the stock markets of different countries. For example, energy stocks have had a wild ride in recent years, while tech stocks have steadily climbed. Financial stocks have been volatile and tied to the movements in the yield curve. As long as these divergent drivers keep sector correlations from rising, country correlations should also remain relatively low.
In our view, the main risk to the trend toward lower correlations is a global event that causes all sectors and countries’ stock markets to move down together, like a global recession. Our view is that a global recession is not on the horizon in the next 12 months, based on historically reliable leading economic indicators and the yield curve, among other factors.
The return to the lower average correlation across stock markets not seen in 20 years has the potential to offer globally diversified investors the benefit of less volatility without hampering returns on the path to financial goals—in essence decreasing risk without decreasing return.