Why Have Global Correlations Increased?

26-Nov-2010

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An eternal optimist, Liu-Yue built two social enterprises to help make the world a better place. Liu-Yue co-founded Oxstones Investment Club a searchable content platform and business tools for knowledge sharing and financial education. Oxstones.com also provides investors with direct access to U.S. commercial real estate opportunities and other alternative investments. In addition, Liu-Yue also co-founded Cute Brands a cause-oriented character brand management and brand licensing company that creates social awareness on global issues and societal challenges through character creations. Prior to his entrepreneurial endeavors, Liu-Yue worked as an Executive Associate at M&T Bank in the Structured Real Estate Finance Group where he worked with senior management on multiple bank-wide risk management projects. He also had a dual role as a commercial banker advising UHNWIs and family offices on investments, credit, and banking needs while focused on residential CRE, infrastructure development, and affordable housing projects. Prior to M&T, he held a number of positions in Latin American equities and bonds investment groups at SBC Warburg Dillon Read (Swiss Bank), OFFITBANK (the wealth management division of Wachovia Bank), and in small cap equities at Steinberg Priest Capital Management (family office). Liu-Yue has an MBA specializing in investment management and strategy from Georgetown University and a Bachelor of Science in Finance and Marketing from Stern School of Business at NYU. He also completed graduate studies in international management at the University of Oxford, Trinity College.







By Jeremy Glaser, Morningstar,

One reason why investors clamor for international stock exposure has traditionally been the belief that foreign stocks have been reasonably uncorrelated from the U.S. market. The theory is that stock markets in different countries will tend to move in different directions at different times. So if the U.S. market has a period of bad performance, perhaps German, Japanese, or Chinese stocks will be doing better. Over time, this diversification could help smooth out returns and provide better long-term returns with less risk.

But is this view accurate anymore? Are investors really gaining diversification when they look abroad? We looked at the difference in correlation coefficients between the S&P 500 and several international indexes to examine what kind of changes have happened during the last 15 years. Our top-level findings were that correlations, especially in emerging markets, have risen markedly during the time period.

The indexes that we tested were:

MSCI All-World ex-U.S.: Tracks a broad cross section of large- and mid-cap stocks from everywhere in the world except the United States.
FTSE 100: Tracks 100 of the largest stocks traded in the United Kingdom.
MSCI EMU: Tracks large- and mid-cap stocks from countries that use the euro.
S&P Latin America 40: A concentrated portfolio of 40 Latin American stocks.
Nikkei 225: Tracks 225 of the largest stocks traded in Tokyo.
MSCI Pacific ex-Japan: Predominantly tracks the markets of Australia, Hong Kong, and Singapore. It does not include Japanese or mainland Chinese stocks.
S&P China BMI: Tracks the universe of firms with predominantly Chinese operations that are available to foreign investors.
MSCI BRIC: Tracks 200 stocks in the BRIC markets (Brazil, Russia, India, and China).
A few caveats before we get to the data. This is far from a definitive study of the issue. The choice of indexes and time periods has an effect on results, as do other issues such as index consecution and currency. However, we think the data does provide a good top-level look at how things have changed over time.

15-Year Correlation Track
To see the related chart, click here:
http://news.morningstar.com/articlenet/article.aspx?id=360365

During the last 15 years (as shown above), correlation coefficients, especially in the emerging markets, have been reasonably low. A correlation coefficient of 1 would imply that the S&P 500 and the foreign index would move in lock step while 0 means that there is no relationship between the two. Of our sample, China has been the least correlated with a coefficient of 0.41 with the BRIC index coming in next at 0.66. Europe tended to hew closer to the U.S. market, and the All World ex-U.S. index comes in at 0.85.

To see the related chart, click here:
http://news.morningstar.com/articlenet/article.aspx?id=360365
When we compress the time period to only the last five years (as shown above) the changes become readily apparent. The coefficient for China jumps up to 0.69, and the all-world ex-U.S. index climbs to 0.91.

To see the related chart, click here:
http://news.morningstar.com/articlenet/article.aspx?id=360365

When evaluating only the most recent year (as shown above), we find that emerging markets have paralleled the U.S. markets fairly closely. The correlation coefficient for the BRIC index is 0.94 while China clocks in at 0.87. The euro countries actually became slightly less correlated and the All World ex-U.S. has a coefficient of 0.92.
Overall there has been a clear trend of emerging markets behaving more like developed markets. And the developed world continued its already-high levels of correlation.

Why The Numbers Have Changed
So does this debunk the theory that investing abroad is a good diversifier? To answer this question, we need to consider some reasons why these numbers have moved during the last 15 years.

The first is simply that large corporations have become increasingly more globalized during the last 15 years. Newly open economies and a quest for growth has given U.S.-based firms the incentive to do more business abroad and for companies in developing markets to make inroads in the U.S. The cross-pollination of revenue sources makes firms in all countries more dependent on the global economy and not just the economy in their home countries. So a downturn almost anywhere in the world is going to have an impact on the earnings of almost all big firms, regardless of their home base.
This effect is made more prominent in the numbers displayed on the charts by the fact that most major indexes tend to be loaded with large-cap names to the exclusion of smaller stocks. It is these smaller companies that are likely to be pure plays on the local economy leaving the indexes heavily weighted to larger more globalized firms. This can have a profound impact on the correlation coefficient. Take Brazil for example. The correlation coefficient of iShares MSCI Brazil Index (NYSEArca:EWZ – News), a broad-market exchange-traded fund, to the S&P 500 was 0.90 during the last year while the Market Vectors Brazil-Small Cap (NYSEArca:BRF – News) ETF had a coefficient of only 0.71.

Another key factor to the high levels of correlation during the last year has been the financial crisis. The credit crunch was a truly global event; there were few corners of the economy in any country that didn’t feel the impact. This means that markets everywhere sold off in huge numbers at the beginning of the crisis, and when the smoke cleared, they all came back in a big way.

The Future Direction of Correlations
So is this higher level of correlation permanent? There is no way to give a definitive answer, but it seems likely that correlations will remain higher than historical averages even if they fall from today’s levels.

First off, interconnectedness is here to stay. Without question China will see more impressive growth than the U.S. during the next 10 years, but U.S. firms are frantically trying to develop bulkheads in China to participate in that growth. This will help further link the prospects of shares in both regions.

And despite talk of the decoupling of fast-growing emerging markets from the slow-growth developed world, the great recession showed that developing nations still rely heavily on exports to the developed world. This reliance will diminish as the consumer market in developing countries picks up. All else equal, we would expect this to force correlations lower.

An additional factor that should reduce correlations somewhat going forward is that as the recovery progresses, there will be more separation between markets. Despite globalization, many stocks’ fortunes are still tied closely to their local markets. As the fog of credit crisis clears and the gulf between the high-performing markets and laggards expands, we would expect performance to eventually follow. That said, correlations should still remain higher than past levels.

The data shows that even though different local economies around the world are growing at vastly different rates, the large multinationals that most investors buy are becoming increasingly interconnected. This has and will continue to make it more difficult to construct an international portfolio that provides true diversification.

But just because correlations have increased, doesn’t mean that investors shouldn’t look abroad. One of the strongest reasons to invest internationally has nothing to do with correlation. It is that the U.S. doesn’t have a monopoly on firms with strong competitive advantages that are trading at a discount. Correlation coefficients say nothing about valuation, so there could always be opportunities for individual investors and fund managers alike to find some cheap gems.


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