Most obviously, how sensitive is the global economy to the U.S. business cycle? As shown in Figure 3, past U.S. recessions have either coincided with—or led to—global slowdowns because the rest of the world's trade and financial markets are linked with those of the United States. Should investors expect the U.S. economy to continue to act as the proverbial "locomotive" for world growth in the years ahead?

Some analysts believe that the world economy has become less sensitive to U.S. developments as a result of rapid growth in emerging markets. Indeed, Figure 4 highlights the growing and outsized contribution of emerging market economies to recent worldwide economic growth. In light of explosive growth in the so-called BRIC economies (Brazil, Russia, India, and China), many analysts wonder whether the emerging markets have "decoupled" from the rest of the world.

As Figure 5 illustrates, as these economies have become more integrated with (and a more prominent share of) the world economy, the correlation of their business cycles to real GDP growth in the rest of world has increased. Do these rising correlations reflect a greater risk of global economic contagion, or do they suggest that the explosive growth of the BRIC economies can help to counteract recessions in developed markets?

In terms of portfolio construction, how have changes in the global business cycle affected the diversification benefits of international investing? Is global diversification at risk? What are reasonable expectations for the correlations between U.S. and international equity returns in the years ahead?

We address each of these questions in turn.

The Global Business Cycle

Over the past five decades, the average correlation among the world's major economic blocks has been positive, but far from perfect. On average, the global business cycle has accounted for approximately 50%-60% of the variation in real GDP growth across the major developed and emerging market economies since 1950.[1] The remaining 40%-50% of the economic variation observed across the four major economic regions has been associated with region-specific and country-specific factors, such as whether a country is a commodity exporter or importer and its level of reliance on international capital flows.

Business cycles in the developed markets have historically been the most highly correlated with the global business cycle by definition, since developed markets represent a large share of the world's total economic output. Between 1950 and 2007, the contemporaneous correlation in annual real GDP growth between the developed markets and the world economy has been 74%. Over that same time period, the collective emerging market economy has had a 39% contemporaneous correlation with the world economy. Generally speaking, the economic correlations between emerging markets and developed markets have tended to be lower than business-cycle correlations among industrialized countries.

1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |