Quarterly Update

When It Comes to Diversification, Don’t Be Naïve

Over the last 30 years, investors have enjoyed a long run of exceptional returns. Supported by extraordinarily healthy business conditions and profit growth, real total returns for global equities in the U.S. and Western Europe have averaged 1.5 and 2.2 percentage points, respectively, above each region’s historical averages. But the global economic landscape is likely to look quite different over the next decade, and those expecting a continuation of this golden age of equity investing may be in for an unpleasant surprise. For advanced economies, major trends supporting economic growth are diminishing or even declining. Labor forces are rapidly aging, productivity gains have stalled and government debt loads are fast approaching levels that significantly curb potential growth. In fact, for many regions and countries, long-term GDP forecasts are at record lows.

The implications for equity investors are significant. Many factors impact equity prices, but long-term stock returns tend to reflect the cash flows (earnings and dividends) generated by companies, which in turn are ultimately driven by economic growth. The link between slower secular growth and subpar equity returns is already apparent in European economies. Over the past five years, City National Rochdale clients have significantly benefited from our bias toward domestic equities (see chart). But as we look forward, we see that even the U.S. is not immune to global trends. The Fed now has a 1.9% long-term trend growth estimate for the U.S., down from more than 3% in 2000.

After asset allocation, the most important decision in portfolio construction is where to invest regionally, and with the outlook for growth muted in the U.S. and elsewhere, we find our heads increasingly turning east. Emerging Asian equities represent some of the best long-term value we see across the global capital markets (see chart). Asia boasts superior demographics, higher savings and investment rates, and rapidly rising urbanization and per capita income. It has a consumer economy that will accelerate as a result of the growing middle class. All this should lead to higher earnings growth.

One key element of investment success is a long-term perspective. With it, investors can assess the impact of fundamental, economic and demographic changes. They can then allocate their portfolios more effectively, focusing on attaining the returns necessary over an extended time horizon to meet their investment objectives. The “free lunch” of naïve diversification is over. However, higher returns and diversification are still possible with a targeted, intelligent approach to global equity investing.

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