Why investors should pay more attention to picking the right countries

Horizons article
November 7, 2023

In the global investment landscape, we are dealing with a high degree of uncertainty in international relations. Since 2018, several conflicts between the world’s great powers have escalated. The U.S. and China clashed over technology. Military conflicts in Ukraine and the Middle East have escalated/are escalating. In reaction, governments are spending massive amounts of capital to reduce their economic dependence on each other. For investors, a key question in this situation is: “how will different countries' financial markets react to these developments?” Based on our research, we conclude that the correlation between Western and other financial markets are likely to weaken, which will create more diversification opportunities for global investors who are willing to focus on country allocation.

When it comes to investing in different countries, we should first remember that the financial markets of countries within the same region are highly correlated. This should not be a surprise: European countries, for example, trade mostly with each other (more than 60% of European trade stays within the continent) and increasingly, so do Asian countries. Because the economies of countries within the same region are highly interconnected, their financial markets also tend to correlate significantly (despite a high degree of globalization between regions).

Furthermore, in the past 15 years, the correlation between regions has been gradually declining. The following graph shows that the degree of correlation between Western and other (Asian, Middle Eastern and Latin American) financial markets has gradually declined over the past 15 years:

Source: Bloomberg L.P. Note: In terms of methodology, for the Asia, Latin America and Middle East portfolios, we used the Spearman’s Rank correlation coefficient (as the optimal distance metric) and Ward's linking algorithm (as the method to arrive at clusters). The data we used were daily returns in local currency. The correlation shown is 1-year rolling.

Looking forward, we believe three interconnected geopolitical trends, not yet reflected by this data, could lead to a further weakening of the correlation between Western and other financial markets in the coming years.

1 – The rise of Asia

The rise of Asia is a fundamental long-term trend. According to Goldman Sachs, somewhere in the next 30 years, three out of the four biggest economies in the world will be China, India and Indonesia (with the United States at number 2). Although most Western investors deem China “uninvestable”, this does not apply to India and Indonesia, which could trigger more significant reallocations of capital between the West and Asia (which we explored in a previous Horizon titled “Are the BRICS+ investable?”), driving larger differences between their financial market performance.

2 – Escalation of conflicts between the world's great powers

We explored the potential of further escalation in a previous Horizon titled “Thinking through the unthinkable: wars in Europe, the Middle East and Asia”. These international conflicts, for the first time in decades, involve the world’s great powers. Our research shows that throughout the 20th century, both the expected returns and the volatility of the financial markets of different countries were highly dependent on whether a country was directly involved in a conflict. This is likely to hold true in the coming years as well, which will drive larger differences between the financial market performances of different countries.

3 – The global push for self-sufficiency

This trend  (which we explored in a previous Horizon titled “How the changing world order could keep the cost of capital high for years”) will drive larger differences between countries for two reasons. First, countries that invest significantly in self-sufficiency will become less dependent on trade, which is likely to weaken their correlation to the financial markets of the rest of the world. Second, only the largest economies are capable of pursuing self-sufficiency, suggesting that differences between larger and smaller countries will grow.

These three trends are part of the global shift of power away from the West and they indicate that geopolitics have become a fundamental factor in driving financial markets. For investors, this will lead to more diversification opportunities. Some countries such as Brazil and Thailand have unique markets that set their performance apart from all other countries. Furthermore, for investors with a preference for democratic countries (a common inclination among Western investors), diversification opportunities can be found in non-Western democracies such as India and Indonesia.


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