The global economic picture seems murkier than at any time since the height of the Great Financial Crisis in late 2008 and early 2009, with lots of questions and few clear answers about a host of risks. These range from turmoil in the Middle East (Libya has already been removed from the oil equation), the Chinese assault on inflation and a never-ending fiscal crisis in peripheral Europe to the Japanese recovery from its triple disasters and a U.S. economy being taken off the life support provided by a steady drip of fiscal and monetary stimulus.
Adding to the fun on Friday were fears that the U.S. government might have to close for business for the first time in 15 years over Washington's peculiar brand of budget politics. This last item was finally enough to toss U.S. equity investors off the wall of worry they had been happily climbing for weeks. The prospect of busloads of securities regulators being laid off for lack of funds was obviously trumped by concerns that Wall Street's deal makers wouldn't be able to find a body to rubber-stamp their latest market offerings.
By contrast, Canadian stocks rose for the fourth consecutive week, buoyed by higher oil and gold prices. It's the kind of divergence that underscores the case for an internationally diversified portfolio, argues Pankaj Ghemawat, a professor at IESE Business School in Barcelona and an expert on global trade and investment. Yet the truth is that investors remain more tethered to their home markets than ever, despite all the fanfare about global capital flows and fast-growing emerging markets.
Research shows that no more than about one-fifth of equities in various global markets were in the hands of foreign investors before the financial crisis struck. And the cross-border ownership of debt did not exceed 35 per cent. Those numbers have obviously fallen since the global downturn, Prof. Ghemawat says. "Our best attempt to work through the data suggests that on average around the world, about 20 per cent of portfolio holdings are in companies other than ones headquartered in one's own country."
That's too low, based on standard theoretical models. Economists have churned out dozens of learned papers seeking to explain the enduring home bias of investors. Fortunately, Prof. Ghemawat has plowed through most of them, sparing us the task. "Every couple of months some finance study announces that the home bias mystery has been solved. Yet it is still a mystery."
It's not surprising that Prof. Ghemawat would be such a strong advocate of investor diversification abroad. After all, we're talking about an Indian-born Harvard grad who teaches global strategy in Barcelona and happily invests in major Spanish banks like Santander, which he says has been unfairly lumped together by investors with the small savings banks, or cajas, that are the source of the country's banking miseries.
I rhyme off a lengthy list of other worries that seem scary enough to convince any investor to steer clear of foreign markets, especially those that may not place a high priority on protecting their interests. When people dump their riskier bets, the first to go typically include those outside their home turf and denominated in increasingly volatile foreign currencies.
"Every place has its dangers," he acknowledges, citing Japan's nuclear woes, the European debt crisis and the massive U.S. deficit, among other issues with no easy solution. He guesses, correctly, that foreign diversification for most Canadians means owning U.S. funds or a handful of American corporate bonds or stocks.
"I would suspect that there's probably some reason [for Canadians]to think about diversifying a bit more broadly," he says. "It's worth thinking about the fundamentals of that economy. If I were a foreign investor in the U.S., I would worry about the fact that, while nobody can predict future exchange-rate movements, there is a clear incentive problem there."
That incentive is to depreciate the U.S. currency over time and thus alleviate its debt burden, warns Prof. Ghemawat, author of a forthcoming book, World 3.0, on why the global economy isn't quite as global as people think.
"To say the world is a frightening place and it's very hard to predict things like what's happening in the Middle East and North Africa, well that is unsystematic risk. And that's exactly what diversification is supposed to iron out. I don't find 'countries are prone to sudden shocks' a compelling argument for home bias, unless we assume there are some systemic effects associated with those shocks."
The idea that diversification could afford some shelter from the storms didn't work all that well during the financial crisis. "There are things that are large enough to overwhelm anything else," Prof. Ghemawat acknowledges. "But the question is: Are you going to go with the strategy that works well most of the time or a strategy that doesn't work any of the time?"