International Diversification

The developed world is depending, and will continue to depend, more and more on the developing world.
The focus of productivity and GDP growth is in Asia.
The U.S. is the only country with trade deficits since 1976.

Introduction

Nobody knows where the market will go in the next week, month, or year, but what can give investors an edge is to look at macro trends that are bound to influence economies and returns on investments.

In this article we are going to analyze productivity and trade balances among the most important global economic powers, and try to derive a long term trend from it in order to improve the international exposure in our portfolios.

Productivity

Productivity is essential for economic development in the long term, and in the short term is only beaten by credit. But as credit has its cycles in the long term, productivity is what determines if a country is a success or not because credit can only be used up to a point. Productivity is the mechanism through which societies progress.

The issue with productivity is that it is stuck globally. This is because productivity is falling in the U.S. and Japan, slowing down in China, and countries like India still don’t manage to compensate for the declines of these superpowers. However, the trend is clear.

Figure 1: Labor productivity growth rates. Source: Conference Board.

The trend shows how the largest global productivity and GDP growth comes from Asia with some bright spots in Africa. As Africa is still undiscovered as an investment opportunity and complicated to invest in, it is good to focus on Asia for international long term diversification.

Higher productivity means that people are achieving more with their own means, education and capital, which improves economics and living standards. This further improves education and healthcare which creates an upward spiral. As Asian countries have a low baseline, there is plenty of room and time for them to develop and grow.

Jim Rogers, co-founder of the famous Quantum Fund with George Soros, is heavily invested in Vietnam. Of course, such an investment is difficult to make as it has many capital constraints at the moment, but it shows you where smart money is going.

A country that is easier to invest in is India, which had a GDP growth rate of 7.3% and productivity growth of 5.2% in 2015. The fact that productivity growth in the U.S. was 0.7% in 2015 and GDP growth was at 2.4% means that GDP growth isn’t exclusively influenced by long term, healthy productivity increases, as is the case in India, but is also greatly influenced by debt. We all know that debt works in cycles, so sooner or later we will see some deleveraging take place that will send the U.S. into a recession, hopefully later than sooner so that we can still enjoy this bull market for a while longer. The situation is the same in Europe; productivity grew at 0.9% while GDP grew at 2.0% in 2015.

Balance of Trade

Among other factors like productivity and credit cycles, the balance of trade (BOT) is a very important factor for assessing the health of an economy. The BOT is often shunned by economist as one country has had a BOT deficit for 41 years and things seem to still go pretty well there. We are of course talking about the U.S. which saw its last trade surplus in 1976.

Figure 2: U.S. BOT. Source: Trading Economics.

This means one thing: the U.S. is spending more than it is producing which is not news, but is good to have in mind when deciding where to go with your global investments.

Other countries—like the U.K., Canada and Brazil—also have BOT deficits, but they have evened out in the long term with past surpluses, with things being a little bit worse for the U.K.

Figure 3: Canada BOT. Source: Trading Economics.

Europe, China and Japan have a surplus in their trade balances.

Figure 4: Europe BOT. Source: Trading Economics.

BOTs show only one side of the equation where usually net investments cover for the trade deficit. But the current account for the U.S. is also negative.

Figure 5: U.S. current account. Source: Trading Economics.

Conclusion

The world will be a very different place in 20 years as global trade, productivity and economic growth shifts from the western world toward Asia. With countries like India and Indonesia reminding us of what China was 20 years ago, we should not be surprised if such a scenario replicates itself in those and other emerging countries.

This doesn’t mean that we should be completely invested in emerging markets, but if we have to choose between a company that has sales only in the U.S. and a company that is selling globally for the same valuation, we ought to go for the global one as global macroeconomic long term trends are clear and unavoidable.

The good news is that emerging markets growth is what will push the currently stuck developed economies forward as increases in global demand will be good for everyone.

Aug

The U.S. Dollar: Should You Stick To It Or Diversify Now?

By Sven Carlin - Central Banks, Dollar, Emerging Markets, FED, FOMC, Interest Rates, International Diversification, Investing Strategy, Investiv Daily, US Economy

The dollar has been positively correlated with stocks for the last 4 years which is unusual.
Potential FED interest rate increases don’t make international diversification a great idea right now.
Any sign of a U.S. recession should be a good time to think about international diversification with emerging markets.

Introduction

On big news sites like Bloomberg you often come across headlines related to the movement of the U.S. dollar. The headline below is a good example.

Such headlines relay what has been going on in the few hours before publication but are completely irrelevant for investors that aren’t trading pips on forex. This article is going to investigate the longer term relationship between the dollar and stocks, and discuss the best option for maximum return with minimal risk.

Recent Dollar & Stocks Movements

Before 2012, as the dollar strengthened, stocks went down and vice versa. The reason was simple, a strong dollar meant U.S. exports were less competitive and businesses suffered, while a weak dollar made U.S. goods cheaper across the world and increased corporate earnings. Since 2012, however, the story has been a little bit different. The dollar has gotten stronger and stocks have gone higher.

Figure 2: U.S. dollar vs. S&P 500. Source: FRED.

The reason behind this is the fact that no matter what we think of the FED, it is the most globally coherent financial institution. In an environment where the European central bank is continuing with stimulus and the Japanese think about printing money for direct spending, the FED is the only institution that contemplates raising interest rates. So the positive correlation between the U.S. dollar and the S&P 500 comes from the relative success of the U.S. economy and the global faith in the U.S. dollar as the only safe currency.

On one hand, the strong dollar lowers corporate revenue. But on the other hand, it also lowers corporate costs, something CEOs never talk about when reporting earnings. As the U.S. has a net trade deficit, the strong U.S. dollar makes everything around the world cheaper and therefore expenses should also be much lower. Don’t forget this in the next earnings season.

Long Term Dollar Strength

The long term perspective is a little bit different than the above. Since 1975, the dollar has slowly but consistently weakened in relation to foreign currencies.

Figure 3: Dollar index since 1975. Source: FRED.

The slow decline of the dollar means that global trends are shifting, which is also normal given the development in China and other countries. As the rest of the world is expected to grow at a faster rate than the U.S., the long term trend for the dollar is clearly and slowly downwards. This point is essential for international diversification. We have discussed many times how China, India and other fast growing emerging markets are essential for healthy diversification.

Forecasts & Economic Factors

In the short to medium term, it looks like the dollar is going to continue to strengthen. If the FED increases interest rates and others continue with their stimulus, the dollar will surge even higher. The most recent FOMC minutes clearly indicate that we could see a rate hike by the end of the year. But, eventually the strength of the dollar will kick back as exports will be more expensive and the trend will turn and continue to follow the declining line seen in figure 3 above.

What To Do

There are two options with currencies. They go up or down and do so for longer periods until the structural influences rebalance on a global scale. With interest rates low and good news from the U.S. economy, the FED will eventually raise interest rates and send the dollar higher. The moment of maximum strength of the U.S. economy and the dollar will be the time to diversify to other currencies but until then, sticking to the dollar is not a bad idea, especially for the majority of our readers who are living in the U.S. If the U.S. economy slows down and the dollar weakens, you will still have most of your assets in your home currency which will not represent a real change to your portfolio. But if you are exposed to other currencies and the dollar gets stronger, you will have to look at losses, which is never pretty.

Conclusion

U.S. investors have the benefit that if the dollar gets weaker, international diversification is just a missed opportunity while if the dollar gets stronger, it was a good idea to stay at home. International investors have to play it differently. With the FED eventually increasing rates, the dollar has no other direction to go than up which is a great diversification play when looking at the stimulus in Europe and Japan which weakens their currencies.

In the long term, it pays to be exposed to the currencies of the countries that are going to grow at a faster pace than the U.S. economy, i.e. emerging markets. We have seen the Chinese Yuan get weaker in the past two years due to some fears about China slowing down, but the longer term trend is clear.

Figure 4: Chinese Yuan per 1 USD. Source: XE.

With the economy expected to grow at a pace of above 6% in the next 10 years and the Chinese getting richer, there is only one way for their currency, up. Think about international diversification, but only when the dollar strength reaches its structural limits and the U.S. is close to a recession.

Aug

Emerging Markets Are Hot – Here Is Where You Should Put Your Money

By Sven Carlin - Brazil, China, Emerging Markets, India, International Diversification, Investiv Daily, Market Forecast, Russia

Emerging markets are up 10% since our last article on the subject, but the FED’s rate action might quickly erase the gains.
Valuations are starting to diverge, but don’t fight the trend.
Keep an eye on China as it is relatively undervalued and still boosts economic growth of 6.7%.

Introduction

In May we discussed how emerging markets have been rediscovered but are still undervalued. Since then, the emerging markets ETF is up 10%.

Figure 1: iShares MSCI Emerging Markets ETF (EEM) since May. Source: iShares.

As emerging markets include a lot of countries and segments, in this article we are going to see which segments in emerging markets are the best investments and which hold the highest risks.

What Has Been Going On?

The central reason emerging markets have outperformed is because investors regained confidence in them and plowed more capital into them, unlike in 2015 when the story was the opposite. The fact that developed countries continue with their monetary easing increases risk appetite and forces investors to search for better returns in riskier assets such as emerging markets. This partly explains why emerging markets asset prices have been pushed higher.

Not only do stocks enjoy the benefit of global monetary easing, but so do bonds. As emerging markets have higher yields, desperate investors pursue those yields no matter the risks. But this is a common trap in which many investors have been caught in the past. Think of Argentina. This is a typical textbook situation, when yields are high and increasing, people pull their money out of emerging markets in fear that things might get worse. But when yields are falling, and it is unlikely that things will get better, people plow money into emerging markets. The emerging markets premium in comparison to U.S. junk bonds is minimal, but let’s not forget that by holding emerging market debt you are often exposed to currency risks.

Figure 2: Difference between yields on emerging markets and U.S. junk bonds. Source: Bloomberg.

Such a low premium suggest that investors should carefully assess the risks before investing in emerging markets at these low yields. But what is pushing emerging markets up is the opposite of what pushed them down in 2015, capital inflows and outflows. Since the beginning of 2016, capital inflows have been increasing.

Figure 3: Total non-resident capital inflows to emerging markets. Source: Institute of International Finance.

With increased capital inflows, asset prices are bound to go up, but not all emerging markets are enjoying the same investor confidence. China is a good example. Global funds toward China are negative as investors fear the further depreciation of the yuan and slower economic growth.

Fundamental Perspective

From a valuation perspective, emerging markets are still undervalued despite the recent upside. The iShares MSCI Emerging Markets ETF (EEM) has a PE ratio of 11.56 and a price-to-book value of 1.56 which is still far from the iShares S&P 500 ETF (IVV) PE ratio of 20.7 and price-to-book value of 2.88. Chinese stocks are the cheapest with a PE ratio of just 8.24 and a price-to-book value of 1.41 for the iShares MSCI China ETF (MCHI).

Figure 3: Emerging markets funds. Source: Wall Street Journal.

As our primary investment thesis back in May was that emerging markets are undervalued, the current price increase and investor unwillingness to invest in China make it the probable future winner. To know more about recent developments in China read our recent article on it here.

As global emerging markets are in an uptrend and far from fair valuations, it might be premature to completely jump exclusively into China and ignore other emerging markets. However, as valuations in other emerging markets continue to increase, creating an even larger divergence from China, it might make sense to “overweight” your portfolio toward China, since in the long term earnings are all that matter.

As a point of reference, the Brazil ETF (EWZ) PE ratio is 13.29 while the Indian ETF (INDA) PE ratio is higher at 21.15. Compared to a PE ratio of 8.24 for China. More daring investors might want to look at Russia where the situation has stabilized but still has low valuations with a PE ratio of 7.36 and a price-to-book ratio of 0.76 for the iShares Russian ETF (ERUS). We’ll discuss more about Russia in a future Investiv Daily article.

For specific investments, the “detailed holdings and analytics” document on the iShares ETFs’ page is a great resource.

Risks

When investing in emerging markets, don’t forget about risk. Drops are sudden and sharp, especially around high valuations and low yields. For example, the iShares China ETF (MCHI) is still 28.5% below its 2015 high.

Figure 4: China ETF. Source: iShares.

The moral of the story is to always look at valuations and don’t get euphoric about emerging markets. Boom and bust cycles are much more frequent than with developed markets due to lower market capitalizations that are strongly influenced by global capital flows which are fickle. We have witnessed two sharp emerging markets declines in the last 12 months—one in August 2015 and the second in January—both of which are a good reminder to not forget that volatility is on the daily menu and another downturn might be just around the corner.

The Fed poses an additional risk to emerging markets if it decides to increase rates due to the tightening U.S. labor market in order to stay ahead of the curve. Higher interest rates in the U.S. would quickly shift capital flows to the less risky U.S. from the riskier emerging markets.

Conclusion

Emerging market are and will stay difficult to navigate. Their volatility is based on low market capitalizations that can easily be influenced with relatively low capital flows when compared to developed markets. Therefore, a good idea is to watch them carefully and not fight the trend because emerging markets tend to move fast in various directions. In January 2016, it seemed like the end of emerging markets was near and now, just 8 months later, it seems all roses.

For investors not exposed to emerging markets, the best thing to do is to look at specific assets that have consistent cash flows and provide diversification. Diversification can also be found in individual companies that have revenues both in the developed world and emerging markets.

Chinese companies have relatively low PE ratios as investors are still not confident about the Chinese economy. Beware that we are not talking here about a recession, but only about growth worries related to China managing to continue growing at more than 6.7% a year.

Stay tuned to Investiv Daily for market updates and specific investment reports on emerging market stocks.

Aug

Forget The News: If You’re Not Exposed to China, You Should Be. Find Out Why.

By Sven Carlin - China, International Diversification, Investiv Daily

Don’t be scared by the news, China is growing strong and has incredible future prospects.
Temporary bumps are and will continue to be normal.
Portfolio diversification with China is essential for increased returns in the future.

Introduction

Exactly a year ago fears around slower economic growth in China, the Yuan devaluation, and oil prices below $40 were the main catalyst for a market correction. The S&P 500 fell from 2102 points on August 17, 2015 to 1867 points on August 25, 2015.

In today’s article we are going to analyze the current situation to see if things are better, or if the market has shifted its focus to other things.

Yuan, Economic Growth and Oil

When the Chinese government devalued the Yuan it spread fears around the globe that the Chinese economy might be doing worse than previously assumed. Everyone knew China was slowing down, but expected growth was still at 7%.

The Chinese government devalued its currency by 3.2% on August 15, 2015. Since then the Yuan has further depreciated by 3.5% against the dollar, but no one seems to care about that anymore.

Figure 1: Yuan per 1 $US. Source: XE, author’s own annotations.

The fear then was that Chinese economic growth was going to slow down more than expected. And while growth has been slightly less than 7% over the last year, it is still growing at 6.7%.

Figure 2: Chinese annual economic growth. Source: Trading Economics.

In order to avoid a hard landing, the Chinese government has taken action. It has forced state-owned companies to increase investments, and it further lowered interest rates to a record low of 4.35% which further increased debt, forcing the debt to GDP ratio to record highs. In its annual review of the Chinese economy, the IMF (International Monetary Fund) stated that policy actions improved the Chinese near term growth outlook but “the medium-term outlook, however, is more uncertain due to rapidly rising credit, structural excess capacity, and the increasingly large, opaque, and interconnected financial sector.”

Increasing debt to GDP means that China is using debt to keep its growth stable which isn’t unusual, but does tell us that without increased debt levels the economy would have slowed down sharply. Current Chinese debt to GDP is 43.9% which is still very little when compared to the U.S. with 104.17%, especially when we know that China is growing at a 6.7% rate and the U.S. at a rate of 1.1%.

Figure 3: Chinese debt to GDP. Source: Trading Economics.

Even the IMF, in its closing remarks, states that Chinese debt is not worrying, especially as China is transitioning from a manufacturing economy to a service based economy which is never a smooth transition.

The final scare last August was that oil prices fell below $40. At the moment oil prices are again around $40, but the S&P 500 is still stable at above 2150 points as this is considered the “new normal.”

Figure 4: Oil prices. Source: Bloomberg.

Local Perspective

In order to better understand what is going on in China, it is a good idea to take a local view which will provide us with a better understanding of the headlines we have read or may read in the future.

Regional data for the first six months of 2016 show that economic growth increased in 15 of the 31 Chinese provinces which indicates that things are, if not turning around, pretty stable in China. On the other hand, difficulties in the coal industry have created a recession in the provinces based on coal and steel production.

Figure 5: Chinese economic growth by province in 1H 2016. Source: Bloomberg.

The chart above is essential for understanding that China is transitioning and therefore economic problems have to be expected, but at the same time, China is still booming. Don’t let negative news about a specific sector or province in China scare you about its future prospects. A longer term perspective will give us a better view of where China is now and where it is headed.

Longer Term Perspective

The GDP per capita indicator is the best way to see where a country is and where it is going. The current GDP per capita in China is $6,416 which is just 12% of the U.S. level ($51,486).

Figure 6: Chinese GDP per capita. Source: Trading Economics.

The low starting level is reassuring for the future as there is still plenty of room to grow. Fears about China should be cast aside when looking at the longer term perspective, and not be reacted to like they were last August as the IMF still predicts that China will grow around 6% for the foreseeable future.

Figure 7: IMF Chinese growth prediction. Source: Knoema.

Conclusion

All in all, we can say that China is doing well and that last year’s August scare was just that, a scare, and a market misperception. China is a large country that still has plenty of room to grow. It is completely normal for it to be a bumpy ride, and seeing what China has done in the past 25 years gives confidence that the country will continue on its growth path, and scary moments can be used to buy investments on the cheap.

Given the positive long term prospects, it might be a good idea, if you haven’t already, to have your portfolio exposed to China. This can be done by buying Chinese ETFs or being overweight in companies that have a large exposure to China. The iShares China Large Cap ETF’s (NYSE: FXI) historical performance shows how investment performance is related to economic growth.

Figure 8: $10,000 invested in the China large cap ETF in October 2004. Source: iShares.

Therefore, with much weaker prospects in the U.S., don’t let frightening headlines scare you. Diversify into China, there is still plenty of room to grow.

Jul

Could It Be A Good Idea To Invest In Japan? There’s Upside Potential…

By Sven Carlin - International Diversification, Investiv Daily, Japan

Price to book is 1.1 and price earnings ratio is at 15.
More monetary and fiscal stimulus can be expected.
Even if the economy doesn’t pick up Japan is relatively cheap.

Introduction

We read a lot about how Japan has been in an economic slump for the past 30 years, how incredibly large amounts of quantitative easing have not triggered inflation, and that Japan should be avoided as an investment opportunity.

In this article we are going to see if any of those concerns have merit by looking at the economy, financial markets, fundamentals, currency risks and rewards in order to estimate the rationality of internationally diversifying our portfolio with Japanese stocks.

The Japanese Economy

Japan was an Asian tiger the 1980s and the burst of the 1989 stock market bubble practically eliminated economic growth. Short growth periods are consistently leveled out by recessions.

Figure 1: Japan’s GDP growth. Source: Trading Economics.

Even with no GDP growth, unemployment in Japan—which currently sits at 3.2%—is very low. Not as low as it has been historically, but still relatively low when compared to other economies like the U.S. with 4.9% or Europe with 10.1%.

Figure 2: Japan’s unemployment rate. Source: Trading Economics.

Japan is suffering from the same disease as most of the other developed economies, an aging population. The labor force participation rate is slowly but steadily declining and is currently at 59.8% (U.S. 62.7%). As a consequence, labor productivity in Japan has been declining for the last 10 years.

In order to bring the Japanese economy to a more stable growth path the prime minister, Shinzo Abe, has embarked on an incredible quantitative and qualitative easing plan. The easing consists of pushing the interest rate below zero and purchasing stocks and bonds on the open market with the goal of bringing liquidity to the market and hopefully spurring inflation. The current interest rate is minus 0.1% and the Bank of Japan has largely increased its balance sheet in the last few years.

Figure 3: Bank of Japan balance sheet and interest rate. Source: Bloomberg.

Monetary policy isn’t the only reason for such a drastic decline in yields. Because the Yen is considered a safe haven, Japanese securities are often used as collateral. This keeps demand high, which also helps to keep rates low. Even still, this has not been enough to spur inflation and now there are even rumors, seeing how inflated the Bank of Japan’s balance sheet is, that it has limited maneuvering space for more quantitative easing. But, Former Federal Reserve Chairman Ben Bernanke rejected this notion as he met with Shinzo Abe to discuss how Japan can beat deflation and implement more qualitative and quantitative easing. The idea is to use “helicopter money” where a central bank directly finances government spending and tax cuts which should inevitably lead to inflation.

There is no guarantee this will happen, but seeing that Japan has had a decade of deflation, anything is possible. As investors, we should look for investments that will do well in an inflationary environment with high levels of monetary easing.

Current Market Situation

Neither the Japanese economy nor the stock market has grown much in the last few decades.

Figure 4: Nikkei index. Source: Yahoo Finance.

However, in the last 5 years it has risen 100% when calculated in the Yen. But given the strong depreciation of the Japanese yen in the last 4 years, it only equates to a 60% rise in US dollars.

Figure 5: USD vs YEN since 2006. Source: XE.

Over the last few months the Yen has actually appreciated against the US dollar. But new easing possibilities might once again lower the value of the yen, which in the last week alone depreciated 4% against the dollar. Investors have to be careful here and differentiate what is real market appreciation or just currency depreciation that affects the Japanese stock market. On the other hand, as the above two figures show, the stock market moves in sync with the currency thus there is at least some protection, currency wise.

From a global valuation perspective Japan is undervalued. Knowing that many products that we use on a daily basis are made by Japanese companies, it might be a good idea to dig deeper into Japanese stocks.

Japan’s Cyclically Adjusted Price Earnings ratio (CAPE – uses 10 year earnings average) is at 20.7 while the U.S. the ratio is 24.7. The normal PE ratio for Japan is also relatively low at 15.2 which is one of the lowest PE ratios in the developed world.

Figure 6: Global PE ratios. Source: Star Capital.

In the long term, investment returns are correlated with underlying earnings, therefore diversifying internationally with cheaper Japanese businesses makes sense. Especially since many of these businesses operate globally. Plus, Japan has a strong legal system, is transparent and has a long positive history towards international investments.The iShares MSCI Japan ETF has an even lower PE ratio of 13.09 and a Price to Book value of just 1.16 which are both much lower than the iShares S&P 500 Core ETF with a PE ratio of 19.55 and a price to book ratio of 2.8.

Future Potential Catalysts and Risks

The first potential boost the Japanese stock market might get is from the new easing program where the central bank will directly give money to the government. This could weaken the yen and make Japanese products cheaper.

The second boost might come from increased fiscal stimulus. The prime minister already delayed the higher consumption tax implementation and more measures should be expected.

The third potential catalyst could come from better corporate governance. Japanese companies have lots of assets sitting on their balance sheets, including cash, and there is a slow trend towards more buyback programs and higher dividends, although this not the usual way Japanese companies operate.

There is always the risk that the stimulus might not work and that Japan returns to the familiar cycle of slow growth with constant recessions. If that turns out to be the case, the low valuations and attractive Price to Book values Japanese companies have, should provide some downside protection. And the fact that many Japanese companies operate globally further mitigates country risk.

Conclusion

In hindsight, it is always easy to explain what happened. Maybe in a few years people will look at the extra returns generated from Japan as pure logic, seeing that the PE ratio is much lower than the rest of the developed world and balance sheets much stronger.

Unfortunately, investing is not done in hindsight. It takes courage to invest in something where it looks like everything should turn out well but has not yet happened. Given the fundamentals and macro trends, Japan might just be the perfect example of how markets tend to be irrational for longer periods of time, allowing patient investors to make extraordinary returns.

May

Investing Down Under

By Sven Carlin - Australia, International Diversification, Investiv Daily

Australia has a stable and transparent economy, is rich in natural resources and the AUD currently looks cheap.
The Australian stock index consists of mostly financials but all have excellent ratings.
Only 0.09% of the S&P 500 revenues are generated in Australia therefore Australia provides additional international diversification.

Introduction

Australia is a country with a population of approximately 23.5 million people, highly developed with a GDP of $47,186 per capita, low unemployment rate of 6.1% and low government debt at 35% of GDP (US 125.3% of GDP). The long term interest rate is at 1.75% and the country is ranked in 13^th place on the global doing business list. The Australian economy grew 3% in 2015 and it is dominated by the service sector representing 68%, followed by the mining sector that represents 7% of the economy. The above seems stable and therefore this article is going to provide an analysis about the potential risks and rewards of investing in Australia.

The Australian Stock Market

The most commonly used index for the Australian stock market is the S&P ASX 200. Even if Australia is famous for its mining industry, the biggest weighting in its stock index are financials with 47.7%, followed, of course, by materials at 13.8%.

Figure 1: ASX 200 Sector breakdown. Source: ASX 200 List.

The financials have the biggest weight in the index as the four biggest companies by market capitalization are banks. All of them have an excellent credit rating which should imply long term stability of the financial system and limit investing risks.

Figure 2: Australian biggest banks credit ratings. Source: Relbanks.

The above credit ratings make Australian banks among the best in the world and they seem even better when compared to US peers.

Figure 3: US bank ratings. Source: Financial Times.

In relation to valuation, the Australian stock market is not cheap with an average PE ratio of 15.7, but it is cheaper than the S&P 500 with 23.88. The dividend yield is also on the Australian side with an average 4.7% yield versus the S&P 500’s 2.12%.

The Australian stock market shows less historical volatility than the S&P 500.

Figure 4: ASX 200 index from 1990 compared with S&P 500. Source: .

Australia seems like a stable country to invest in but before directly investing the currency issue has to be assessed.

Australian Currency

With international investing, currencies play a big, if not main role. Economic growth and dividends might not mean much to an investor if currency losses eat up the gains. The main influences on the Australian dollar (AUD) are the interest rate, imports, exports and the stability of the economy.

On May 3, the Reserve Bank of Australia decided to lower interest rates to a record low of 1.75%. Historically the average has been 4.92%. A low interest rate should imply a weak currency as investors look elsewhere for higher yields. An even more important factor for the AUD are commodity prices as the mining industry that comprises 7.4% of GDP is exporting most of its goods. Australia mainly exports iron ore (25% of exports), coal (15%), oil (10.4%) and copper (2.1%). If commodity prices are high then more AUDs are needed to pay mining expenses and therefore the AUD is stronger. In relation to GDP growth and economic stability, the International monetary fund forecasts the Australian economy to grow at a stable rate of around 2.8% for the next 5 years.

Figure 5: AUD per 1 USD. Source: XE.

The above mentioned influences result in a very volatile currency that is very strong when commodity prices are high and weakens as commodity prices drop. The AUD has depreciated against the US dollar by more than 30% in relation to the USD in the last 3 years. A recovery in commodity prices could give a boost to the Australian economy, increasing interest rates and increasing the value of the currency.

Conclusion

International diversification is a very controversial topic as both practitioners and academics constantly research and discuss it. The S&P 500 already generates more than 50% of its revenue overseas so further diversification might be questionable, but Australia stands out as only 0.09% of the S&P 500 revenues are generated Down Under.

Apart from uncorrelated revenues, Australia also offers political and legal stability, economic transparency and a relatively high dividend yield and low PE ratio. The currency will for sure be volatile towards the USD but that volatility might increase the positive returns as the AUD has only been falling in the last few years alongside the fall in commodities.

Apr

On International Diversification

By Sven Carlin - International Diversification, Investiv Daily

Markets are more correlated in the short term but strongly diverge in the long term.
Currency movements further fuel international divergence.
Being overweight a certain market or currency means carrying additional risks that could be removed by international diversification.

Introduction

One issue that is more often off than on investors’ minds is international diversification. Historically, cross-country equity correlations have been far from perfect but they are becoming more correlated in recent times. The higher correlation is not a reason to shun international diversification.

Figure 1: Cross-country correlation of stocks and bonds. Source: Viceira, Wang, Zhou – Harvard Business School.

The main point behind international diversification is that due to the lower correlation between markets it should lower the risks by smoothening the volatility of a portfolio for the same expected return. This happens because the international part of the portfolio is less likely to be affected by domestic market changes. The globalization of trade flows and higher capital markets integration increased the international correlation among markets and consequently lowered the potential benefits. But, as correlation is always measured in the short run, in the longer term it should bring to the expected benefits of reaching the same returns with lower risk because the long term correlation is much lower.

Lower Long Term Correlation of International Markets

The long term correlation among international markets is lower than the short term due to several reasons. The first one is that even if in the short term the global integration of capital markets makes it look like they are correlated, in the longer term structural influences prevail. The following two figures show the difference between short and long term correlation.

Figure 2: 1-year correlation between the S&P 500, AEX (Dutch index), iBovespa (Brazil) and FTSE (UK). Source: Yahoo.

The difference among the above indexes in one year is only 10% with the AEX being the worst performer. This small difference makes investors forget about international diversification. But in the long term things are completely different.

Figure 3: 10-year correlation between the S&P 500, AEX (Dutch index), iBovespa (Brazil) and FTSE (UK). Source: Yahoo.

In the longer period of 10 years the differences are much larger. The Brazilian index is the most volatile and the S&P 500, AEX and FTSE move along for a while but strongly diverge in the total period. The above figures show the movement of the relative stock market indices without taking into account currency effects. Currency effects are the second important factor in international diversification. The below figure shows the example of the USD/EUR currency pair.

Figure 4: USD/EUR currency pair from 2006 to 2016. Source: XE.com.

On top of the previously explained market divergence the dollar strengthened in relation to the EUR from 0.62 EUR per 1 USD in 2008 to the 0.95 EUR per 1 USD. That represents a divergence of more than 50% and shows how the currency effect can influence international correlation in the long term. Currencies are strongly influenced by economic trends and that is the third factor influencing international correlation.

Economic Influences

The below cumulative GDP growth chart shows how countries experience different growth levels in longer periods. The UK and the US have grown 50% faster than the Netherlands while Brazil grew 100% faster than the US in the period from 2000 to 2015.

Figure 5: Cumulative economic growth for the US, UK, Netherlands and Brazil from 2000 to 2015. Source: World Bank.

Economic divergences are a consequence of longer term structural effects and global cycles. Currently the Euro is considered weak due to the low interest rates in Europe, slow economic growth and no short term positive economic catalysts on the horizon. On the other side, due to the weakness of the currency European products are cheaper internationally and that could influence faster economic growth in the future. In the meantime, the strong dollar makes US products globally more expensive and this could lower the currently stronger economic growth of the US.

The above long term factors also lower the risk of a portfolio in a long term and are important factors to think about when investing. But, even if the benefits of portfolio diversification are clear in the long term, investors stick to their domicile markets. This phenomenon is called the equity home bias puzzle.

Equity Home Bias Puzzle

An interesting feature in the international markets is the home bias. It describes the tendency to invest the largest part of one’s portfolio in domestic securities despite the benefits of international diversification. University of Chicago researchers, Moskowitz and Coval have found that specifically US investment managers exhibit a strong preference for locally headquartered firms that often create asset pricing anomalies. A Morningstar research in 2013 found out that US mutual fund investors keep only 27% of their equity allocation in not US domiciled funds while the Equities not domiciled in the United States accounted for 51% of the global equity market. It is logical that investors prefer the familiar but each investor should assess its own exposure to a certain currency and evaluate his long term risks related to that exposure.

The Strength of the Dollar

Being overweight one market means betting on the success of that currency or market in relation to other markets and currencies. Therefore, such an overweight investor has to assess potential international macroeconomic influences on his portfolio. Such long term economic shifts are very difficult to time and therefore considered betting. US investors have had a great investing performance in the last few years with Europe starting quantitative easing, commodities, that are the main wealth resource of emerging markets faltering and China experiencing a soft landing. But, the below figure that compares the US dollar to a basket of foreign currencies shows how risky an overweight currency strategy can be.

Figure 6: US dollar index from 1967 to 2015. Source: Wikimedia.

An astute investor could also use the above evident shifts and allocate different weights to various markets in relation to their current weakness but that is a different story and requires high macroeconomic knowledge and insight.

Conclusion

The main idea behind this article is to give food for thought. International diversification might not be relevant in the short term but in the longer term it can provide certain benefits. There are various ways of being internationally diversified, through buying different indices or by buying stocks of the same sector that have a different geographic focus. A clear example for that are utilities, they provide relatively stable returns and dividends and when dispersed internationally can lower the volatility of a portfolio.

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