One of the drawbacks of investing offshore is that the benefits of international diversification vary considerably over time and between markets. In bear markets, for example, the correlations between international equity returns tend to increase, particularly among the major industrial markets. This is not good news for investors because it makes avoiding share market slumps very difficult. If you invest outside your own market, you just end up losing money in more places!
So is moving out of equities altogether the only solution in bear markets? Maybe not, according to a recent US study by Conover, Jensen and Johnson (2002). The authors examined the performance US, major market and emerging market equities during the period 1976-1999, with a particular focus on the impact of US monetary policy settings. One of their key findings was that investment returns in emerging markets appear to be less responsive to US interest rates than those in major industrial markets.
In fact, an environment of rising US interest rates, which is usually negative for major share markets, was invariably the best time to invest in emerging markets. During their sample period, the inclusion of emerging market equities improved portfolio returns by about 1.5% p.a. but virtually none of the gains occurred when US rates were falling. In contrast, for periods of restrictive US monetary policy, the addition of emerging market shares boosted total returns by around 4.5% a year.
So far this year, emerging market equities have risen by 4.9% in US$ terms compared to an 8.9% fall in the MSCI World Index. This out-performance has surprised many analysts who thought that terrorism fears and rising US interest rates would stymie volatile financial assets like emerging equities. But if US interest rates are heading higher, there could be further gains to come.
Conover, C.M., Jensen G.R., Johnson R.R., “Emerging Markets: When Are They Worth It?” Financial Analysts Journal, Vol.58, No.2, March/April 2002.