This paper conducts a theoretical and empirical investigation of the risk of globally diversified portfolios of stocks and bonds and of optimal intertemporal global portfolio choice for long horizon investors in the presence of permanent cash flow shocks and transitory discount rate shocks to asset values. An increase in the cross-country correlations of cash flow shocks raises the risk of a globally diversified portfolio at all horizons. By contrast, an increase in the cross-country correlations of discount rate shocks has a much more muted effect on portfolio risk at long horizons, suggesting that the benefits of global portfolio diversification to long-term investors do not recede when the source of increased global return correlations is correlated discount rates. Empirically, we document a secular increase in the cross-country correlations of both stock returns and government bond returns since the late 1990's. We identify increased correlations of discount rate shocks resulting from financial globalization as the main driver of the upward shift in stock return correlations. We also identify increased correlations of inflation shocks as an equally important source of the upward shift in bond correlations. By contrast, we don't find evidence of a secular shift in the cross-country correlations of stock market volatility shocks, which have remained fairly low through time except during the financial crisis of 2009.
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