Financial Globalization and Its Implications for Diversification of Portfolio Risk

Abstract

Trade disputes and the impact of the COVID-19 pandemic on global supply chains have drawn much attention to the notion of “deglobalization.” The common concern is that the steady trend of globalization and its many benefits may reverse. But the globalization trend is not a monolith. In this article, we show that although trade globalization has stalled since the Global Financial Crisis (GFC), financial globalization has continued to increase. We further show that financial globalization has a much more significant impact on portfolios than trade globalization. The primary mechanism of this impact, US dollar hegemony, impacts portfolios primarily through increased spillover of US monetary policy shocks. The two implications for investors are: (1) global equity markets have become increasingly correlated and are likely to stay that way, and (2) this increased correlation reduces the benefits of portfolio diversification and leads to a more concentrated exposure to US monetary policy shocks.

Key Findings

• ▪ Financial globalization has increased steadily even as trade globalization has stalled over the past decade.

• ▪ Increased financial globalization amplified by increased US Dollar hegemony raises the correlation of global equity markets, reduces efficacy of geographic diversification, and concentrates exposure to US monetary policy shocks.

• ▪ Therefore, investors must step beyond the simple equity/fixed income paradigm to consider other opportunities to diversify equity risk such as commodities, currencies, alternatives, or low volatility strategies.