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When we talk about diversification, we are usually referring to asset classes. Equities, bonds, commodities and property all behave differently and on different time-scales. That is why holding a mixture of these can deliver a smoother ride for investors.
Geographical diversification is sometimes less important because equity markets in different regions often move in lockstep. As they say, when Wall Street sneezes the rest of the world catches a cold. The scale of gains or losses may differ but the direction of travel tends to be the same.
This might be the norm but this year markets have not moved in parallel. Unusually there has been a significant divergence between the best and worst markets. In particular, the US and emerging markets have parted company.
So far this year, the S&P 500 has risen by 8%. The main benchmark and the Nasdaq too have continued to hit new highs as the 10-year bull market in US stocks has run and run. By contrast, emerging markets (notably China) have fallen into bear market territory, more than 20% below their peak earlier in the year.
If you want to know why this has been so, you don’t need to look much further than the White House. Donald Trump claims the credit for many things but when it comes to the outperformance of Wall Street he might have a point.
That’s because the key driver of the US stock market’s gains this year is the tax reform programme he pushed through Congress before Christmas last year. It has resulted in a corporate profits bonanza in 2018 and that has, single-handedly, made the US market look reasonable value again.
Having started the year valued at 18 times expected earnings of $147, the S&P 500 index is now valued at less than 17 times forecast earnings of $173. The market has risen fast but earnings have gone up even faster.
The tax reforms have had an enormous impact. Adding together $700bn of cash being repatriated by American companies, $80bn of corporate tax cuts, $120bn of cuts aimed at individuals and $100bn of new Federal spending, you quite quickly get to a very big boost to the US economy.
The White House might not be so directly responsible for the slide in emerging market shares but it can certainly take some of the blame. That’s because the fiscal boost to the US economy has provided the cover for the Federal Reserve to continue tightening monetary policy faster than anywhere else in the developed world. And that, in turn, has led to a material strengthening of the US dollar.
A rising dollar is bad news for emerging markets for a few reasons. First it reduces the incentive for US investors to seek returns in overseas markets because they can generate a more than acceptable return at far less risk by staying at home. Second, it makes it more difficult for overseas borrowers (many of which are emerging market governments or companies) to service their dollar-denominated debts. Finally, weaker currencies exacerbate the threat from inflation as imports become more expensive.
Clearly, some countries (like Turkey and Argentina) are more exposed than others. But once investors become more risk averse, the chance of wider contagion rises. Add to this a slowdown in China, which is becoming a key destination for emerging market exports, and it is not hard to see why emerging markets have been under pressure.
That’s the bad news for emerging market investors. The good news is that some of the damage has already been priced in. And, for contrarians, emerging markets are starting to look interesting.
Of course, no-one can be sure when the bottom might be for emerging markets nor when or if the bull market in US stocks might end. This argues for balance and diversification. If emerging markets do continue to fall then the attraction of the US will increase. A bit of both looks sensible.
Three ways of achieving this balance spring to mind. The first is to invest in a diversified fund like the Fidelity Select 50 Balanced Fund which holds not only different assets but also spreads its investments across different geographic regions, including both the US and emerging markets.
A second way is to invest in a global fund, which will tend to have a greater exposure to the US because of its size but will also invest across emerging markets too.
Next week, I’ll be launching my latest Investment Outlook on Tuesday 18th September at 12 noon. Join the conversation at www.fidelity.co.uk/investmentoutlook.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.