## The Rewards of Rebalancing

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**Canonical URL:** [The Rewards of Rebalancing](https://www.imf.org/-/media/files/publications/fandd/article/2026/09/kapoor.pdf)

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### Distorted capital map
- With just 4 percent of the world’s population, the US accounts for about two-thirds of global stock market capitalization and nearly 40 percent of bond markets.
- The US accounts for only 9 percent of global growth, 13 percent of trade, and 15 percent of global economic output on a purchasing-power-parity basis.
- Long-standing phenomenon: global savings have flowed from younger, faster-growing economies to slowing, aging ones (the “Lucas paradox”).
- Consequences of the distortion:
  - Inflated US asset prices.
  - Increased correlations across global portfolios.
  - Capital scarcity in economies where it would most diversify risk and raise productivity.
- US advantages that sustained the concentration: the world’s deepest capital markets, a formidable innovation ecosystem, powerful companies, and the dominant currency.

### Diminishing tailwinds
- Historical tailwinds behind US asset outperformance included:
  - Declining interest rates.
  - Lower corporate taxes.
  - Quantitative easing.
  - A strong dollar.
  - Fiscal indulgence.
  - A growing share of income flowing to capital over labor.
- Foreign investors tripled their exposure to US equities to more than $20 trillion over the past decade.
- Evidence of reversal:
  - Turn in the strong dollar cycle; hedging dollar exposures has become more expensive, turning a past tailwind into a headwind.
  - A weaker dollar increases the relative attractiveness of emerging market and developing economies and has driven their significant outperformance since early last year.
  - Room for further cuts to US taxes and interest rates is limited; both are as likely to go up as down given the ballooning deficit and persistent inflation.
  - The Federal Reserve is moving toward quantitative tightening, away from the peak $9 trillion in asset purchases seen earlier.
  - Lower interest expenses and lower corporate taxes alone explain more than 40 percent of the real growth in US corporate profits between 1989 and 2019; lower risk-free rates explain the expansion in price-earnings multiples over that period.
- Market concentration concerns:
  - In the past three years, just seven companies accounted for 55 percent of total S&P 500 returns.
  - The top 10 companies now make up 40 percent of the index.
  - Gradual erosion of the traditional safe haven status of US Treasurys in fixed income.
- Implication: Expected profit growth and equity returns in the US are likely to be materially lower as these tailwinds fade.

### Capital shifts
- Rebalancing will be gradual and start at the margin, but even modest allocation changes have large macroeconomic effects due to the US’s large share in global portfolios.
- Example calculation: Norway’s $2.2 trillion oil fund allocates 53 percent of holdings to US assets; trimming to 40 percent would free up about $250 billion for investment elsewhere.
- Trillions of dollars from pension funds, insurers, and sovereign wealth funds could be redeployed:
  - Some to developed economies: United Kingdom, the euro area, and Japan (where valuation multiples remain more modest and index concentration is far less pronounced).
  - Much to emerging market and developing economies, which offer the most opportunity:
    - Emerging economies drove three-quarters of global growth in recent decades.
    - China and India alone accounted for nearly half of global growth last year, three times the combined contribution of the US and the European Union.
    - India and sub-Saharan Africa will each gain more than 12 million workers every year.
    - Labor productivity growth in emerging market and developing economies is about 3 percent, more than three times the average for advanced economies.

### The risk-return case
- Market representation mismatch:
  - Emerging market and developing economies accounted for only about 11 percent of global equity market capitalization and 26 percent of bond markets at the end of 2025, a fraction of their much larger share of global GDP.
- Closing the gap would:
  - Plug the annual financing gap of more than $4 trillion.
  - Lower financing costs for these economies, aiding climate mitigation and adaptation investments sensitive to financing costs.
- Convergence of risk profiles:
  - Advanced economies’ public debt: 108 percent of GDP.
  - Emerging market and developing economies’ public debt: 75 percent of GDP.
  - Gaps in currency volatility and sovereign default rates have converged.
  - Several emerging economies now have lower public debt ratios, more orthodox monetary policy, stronger reserve buffers, and greater policy predictability than many developed economies, including the US.
  - Political risk is converging as rising polarization and instability in many advanced economies increase policy risk.
- Implication: Investors no longer need significantly higher returns from emerging economy portfolios at the portfolio level; rebalancing offers robust returns, limited riskiness, and substantial diversification potential.

### Portfolio optimization
- Emerging market and developing economies provide structurally different returns:
  - Different demographics, currencies, politics, policy regimes, and sectoral composition.
  - Generally lower correlations between these markets and developed markets, enhancing diversification.
  - Smaller, less integrated emerging economies offer additional diversification benefits.
- Many “global” portfolios are concentrated bets on US equities, Treasurys, the dollar, and a small group of tech companies; this increases vulnerability due to elevated valuations, market concentration, and rising correlations.
- Rebalancing rationale:
  - Follows from institutional investors’ fiduciary obligations to maximize long-term risk-adjusted returns.
  - Moving allocations closer to these economies’ weight in the world economy will lower financing costs, boosting investment, jobs, and growth and supporting a more resilient, low-carbon economy.

### Policy priorities to unlock rebalancing
- Identified barriers that could slow rebalancing:
  - Weak project pipelines.
  - Misaligned incentives.
  - Perverse regulations.
  - Investors’ general unfamiliarity with these markets.
- Recommended priority: Remove these barriers to unlock stronger, more balanced global growth and to reward investors with higher risk-adjusted returns.
- Outcome ambition: Rebalancing could help address the Lucas paradox by redirecting capital to faster-growing economies where it can raise productivity and diversify global portfolios.

*Source: Sony Kapoor, F&D, September 2026.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2026/09/kapoor.pdf_