The increasing importance of global diversification
Major equities indexes did well last month including the S&P/ TSX, S&P 500 and the three major European boards. The one exception, the Nikkei 225, registered slight losses. However the Japanese index, which had gained a stunning 32.5% as at the end of May, in local currency terms, provides an excellent illustration of why professional investors tend to diversify their portfolios internationally.
The importance of spreading stock purchases among several economic sectors is well-known. Owning equities in the consumer products, energy, finance and other industries helps investors smooth out gains (and limit the losses) which come with normal economic and cyclical patterns.
However Canadian stocks comprise only a small proportion of global equity markets. Professional investors have long learnt to overcome this shortfall, by also holding equities in other major countries, particularly the United States. Canadians that hold stocks south of the border were amply rewarded during the first five months of 2013 (as the S&P 500 outperformed the S&P/TSX 14.34% v. 1.74%, before dividends, in local currency terms). In recent years Europe and Asia have also increasingly emerged as attractive alternatives.
An interconnected world
In fact international capital movements have evolved so far that many analysts have noted that the increasing interconnectedness of major global economies has caused stock markets to move in tandem as well. The fact that major western equity exchanges gained ground, in tandem, since the start of the year provides a perfect example.
However these patterns must not be overstated. There remain significant differences in regional stock market and economic performance. The International Monetary Fund has recently been talking about a “three speed,” global economy made up of distinct groups. The first consists of emerging markets such as China, India and sub-Saharan Africa, in which gross domestic products are projected to grow faster than 5.0%. The second group consists of the United States, Canada and several others which are lumbering along striving to reach the 2% to 3% growth range. Trailing, are many euro zone and other nations which are trying to stay out of recession.
Fundamentals aside, the different economic moods in various parts of the world (“the animal spirits” as Adam Smith called them), provide reason of their own to diversify. The massive year-to-date increases in the Japanese market (as well as the 5% one-day drop in early June) were in large part based on emotions.
True, Japan is starting to see strong growth, following massive fiscal and monetary policy stimulus, which comes after an almost two-decade long economic funk. However much of the rise in major stocks was due to hopes that things might have permanently turned the corner. Nobody can be completely sure whether that is true. That said, those that diversified their portfolios internationally will have partial protection or partial upside either way.
In recent years it has been getting easier to invest outside of Canada. Increasingly sophisticated electronic markets make it easy to buy and sell stocks at the click of a button. And for those who do not have the time to track individual companies, global economic swings, changes in tax policies and the intricacies of foreign markets, mutual funds continue to provide an attractive alternative.
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Peter Diekmeyer Communications Inc.