How worried should retirees be that the Chinese stock market is now in a bear market—having dropped by more than 20%?
It’s an important question because it seems like few others are even paying attention. Wall Street appears to be comforted by the S&P 500 SPX, +0.49% being up for the year, if modestly. But that’s little solace for retirees whose portfolios are often significantly diversified into non-U.S. stocks.
How unusual is it for a leading foreign stock market to diverge so significantly from the U.S. market? When such divergences do occur, do they mean that the U.S. market is likely to soon catch up to the rest of the world, or vice versa?
It’s a cliché these days to say this, but the core insight that allows us to understand these and related phenomena is that the world’s financial markets have become increasingly interconnected—dramatically so, in fact. This means that, while the divergence we’re currently seeing between U.S. and Chinese stocks would not have been all that unusual many years ago, it has become increasingly rare in recent decades.
It’s easy to quantify the degree to which the markets have become interconnected. Take a look at the accompanying chart, which plots the correlation over the trailing five years between U.S. and foreign equities. A high coefficient (approaching +1) means that the two have more or less moved up and down in lockstep, while a low reading (closer to 0) means that the two march to the beats of separate drummers. (I constructed the chart by focusing on MSCI’s EAFE index, since for most of the last 50 years the Chinese economy and stock market were tiny compared with those of the U.S.)
Notice that the correlation reached a low point in the late 1990s around 0.20, but then shot up and has been at or above 0.70 for most of the last 20 years. Though this dramatic jump was no doubt due to many factors, the immediate trigger of that late-1990s jump was the July 1997 financial crisis in which a series of currency and sovereign debt emergencies led to fears of a world-wide economic meltdown. (These crises began in Asia, which is why many refer to what happened that summer as “Asian contagion.”)
Another contributing factor to the increasing correlation between U.S. and foreign equities has been the growing share of U.S. corporations operations that come from overseas. Currently, for example, around half of all U.S. publicly traded firms’ sales come from overseas.
There are several important investment implications of this increasing correlation:
•The current divergence between the U.S. and Chinese markets is unusual, and to that extent is unlikely to persist. Unfortunately, the historical record doesn’t help us forecast whether this means that U.S. stocks will soon enter a bear market in order to become more correlated with the Chinese market, or whether Chinese equities will soon rally to catch up with the U.S. In an interconnected world, no one market can be the tail that wags the rest of the world’s dog.
•If the equity portfolio of your portfolio is diversified among both U.S. and non-U.S. stocks, however, it makes relatively little difference which market is likely to catch up with the other. To that extent, so long as you are diversified, the answer to the question with which I began this column is that you do not need to be unduly worried about what’s happening to Chinese stocks.
•To a greater extent than ever before, you get automatic international diversification by investing in just U.S. equities. An S&P 500 index fund today, for example, will be as diversified internationally as a portfolio 50 years ago that allocated 50% to that index fund and 50% to non-U.S. stocks. That’s the good news.
•The bad news: You gain fewer benefits today than in decades past from international diversification. We no longer live in a world in which what happens to an economy half way around the globe has relatively little impact on our own. To gain the same extent of that earlier era’s diversification, we will have to look beyond equities to other asset classes altogether. Which other asset classes you should look to for such diversification will have to be subject of another column.
Meanwhile, we’re left to marvel at how our selective attention can divert our collective gaze from a greater than 20% drop in the leading stock market benchmark (the Shanghai Composite SHCOMP, +0.26% ) from the world’s second largest economy. My hunch is that we all will soon be reading a lot more about what’s happening to the Chinese economy in general and stock market in particular—and how it impacts the U.S.