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Correlation stations – the search for diversification
Against a backdrop of historically top-heavy global equity markets, where might investors look for potential diversifiers?
On the Asset Allocation team, we have written extensively about the importance of diversification[1]. However, with global equity markets increasingly dominated by a small number of stocks, it can often feel as though your entire equity allocation is to the US technology sector. So where might one look for differentiated returns?
Our chart of the month attempts to answer this question by showing the correlation of regions and sectors to the US equity market and how this compares with history. The size of the circles represents the combined market capitalisation of the group. We see three key takeaways for investors looking to build more diversified portfolios.
First, there has been an ‘Americanisation’ of sector indices, with 80% of global sectors becoming more correlated to the US market. While technology and consumer discretionary will come as no surprise, the relative lack of diversification offered by ‘old-economy’ sectors such as industrials and materials is perhaps less obvious.
However, diversifiers still exist. The energy sector has been by far the least correlated part of the equity market, possibly due to the collapse in energy sector market capitalisation and the different fundamental drivers between oil and gas companies and US technology stocks. Asia and emerging markets also offer potential differentiation and are typically underrepresented versus their economic significance in most investor portfolios.
Finally, classic diversifiers such as Japan and utilities have seen a major increase in correlation to the US in the past five years. While both continue to exhibit some degree of independence, we believe that their diversification benefits could be significantly lower than in the past. While there is no clear driver of the shift, the sensitivity of both to macroeconomic factors such as interest rates may play a role.
Our takeaway? Perhaps there is room for a little more energy and emerging market exposure for investors looking to diversify their equity portfolios.
[1] It should be noted that diversification is no guarantee against a loss in a declining market.
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