Over the past decade, globalization has increased the
interdependence of nations among each other. With the growth and
advent of technology, businesses and capital flows are no longer
limited within a given nation.
As a matter of fact, foreign institutional flows in the form of
direct investments as well as portfolio flows are major indicators
of economic health and stability for a country. A nation with high
foreign fund inflows is perceived to have a healthy investment
climate and a favorable political situation (read Four ETFs for
Obama’s Second Term).
Yet while the interdependence may sound like a good thing all
around, it also has its drawbacks and can promote a quick spread of
economic contagion. This means that a slowdown in country A, would
directly/or indirectly impact the economic growth and development
of country B.
A classic example of this is the sub-prime mortgage crisis and
the euro zone debt crisis. Apart from the U.S and the euro zone
members which were directly impacted, emerging markets like China
and South Korea were also impacted as the infected western
countries are a major export market for the Asian giants and
account for decent chunk of their trade balance (see more in the
Zacks ETF Center).
From a stock market perspective as well, the economies are
closely tied up. Over the past decade, stock markets across the
globe have been exhibiting strong correlations among each other. Of
course, with increased globalization for the same time period, this
was pretty much inevitable.
It is prudent to note a couple of factors in this regard.
1) The correlations tend to become stronger during
times of economic crisis, 2) Developed nations have a stronger
correlation among each other than emerging
nations.
The following table summarizes the stock market correlation of
different nations to the U.S stock market (i.e. S&P 500) over
the past decade and highlights various events which have taken
place over that time period.
Table 1: Correlation of Country Specific Stock
Indices to The S&P 500
Year
|
FTSE 100 (Great Britain)
|
KOSPI (South Korea)
|
DAX (Germany)
|
IBOV (Brazil)
|
ASX 200 (Australia)
|
Crisis
|
2002
|
96.22%
|
71.21%
|
95.44%
|
67.97%
|
90.93%
|
Post 9/11 Terror Attacks, accounting scandals,
dot.com bubble
|
2004
|
38.24%
|
45.48%
|
65.45%
|
35.74%
|
62.88%
|
N.A
|
2009
|
88.95%
|
71.23%
|
93.00%
|
69.54%
|
87.22%
|
Sub-Prime Mortgage Crisis and Bank
Failures
|
2011
|
95.46%
|
64.00%
|
81.97%
|
84.03%
|
92.07%
|
Euro zone Sovereign Debt Crisis
|
Overall (for 12 years)
|
87.59%
|
65.20%
|
82.19%
|
70.45%
|
82.53%
|
N.A
|
12 year average
|
81.36%
|
67.44%
|
80.80%
|
70.87%
|
80.56%
|
N.A
|
Note: Correlation Calculated Using Monthly
Returns
As evident from the table above, during desperate times, the
correlation between the stock markets tends to increase. As a
matter of fact during the crisis of 2002, 2009 and 2011, the
correlations of the above mentioned nations tended to increase
substantially.
However, it is also seen that during 2004 when all was good, the
correlations had dropped to significantly low levels.
One reason for this could be the risk-aversion which engulfs
investors during periods of global economic uncertainty. These
periods experience huge sell-offs from the equity markets across
the board. Therefore, this similar trait across global equity
markets is bound to result in significantly high correlation during
periods of high economic uncertainty (read What Do Quarterly Trends
Reveal about ETFs in Q4?).
Also, in this experiment, the developed nation’s stock indices
(i.e. FTSE 100 – Great Britain, DAX – Germany and ASX 200 –
Australia) have shown significantly higher correlations to the
S&P 500 than their emerging market counterparts (i.e. KOSPI –
South Korea and IBOV – Brazil).
Given this fact, it is prudent to note that traditionally fund
managers and investors look beyond their domestic region as a means
of achieving portfolio diversification. However as we have already
discussed, over the years, global equity correlations have
increased substantially. This reduces the diversification benefits
that investors seek by placing their bets on different regions (see
Inside The Two ETFs Up More Than 140% YTD).
To showcase this phenomenon with investable products, we have
used five country specific ETFs and quantified their correlations
with both the U.S stock markets and their domestic stock markets as
well.
The ETFs used are iShares MSCI Australia ETF
(EWA), iShares MSCI South Korea
ETF (EWY), iShares MSCI United
Kingdom ETF (EWU), iShares MSCI
Germany ETF (EWG) and iShares
MSCI Brazil ETF
(EWZ).
These ETFs are chosen as they exhibit the broad market sentiment
of the nation that they track (although it should be noted the
correlation will usually never be 1.0 anyway as the benchmarks the
ETFs track are slightly different from many broad domestic stock
indexes).
Table 2: Country ETF correlations with domestic as
well as U.S. Stock Index
ETF
|
Country
|
Correlation With Domestic Stock
Index
|
Correlation With U.S. Stock Index
|
EWA
|
Australia
|
0.84
|
0.88
|
EWY
|
South Korea
|
0.87
|
0.83
|
EWU
|
Great Britain
|
0.90
|
0.90
|
EWG
|
Germany
|
0.92
|
0.88
|
EWZ
|
Brazil
|
0.90
|
0.75
|
Note: Data used is weekly returns over a period for
the past 3 years
As we can see, the coefficient of correlation for these ETFs is
almost the same for their domestic stock markets as well as the U.S
stock markets. Also, the emerging market ones (i.e. EWY and EWZ)
are less correlated to the U.S. markets than their developed market
counterparts (i.e. EWA, EWU and EWG).
The Bottom Line
Traditionally, these ETFs seek to provide international
diversification. However, these high correlations clearly suggest
that they fail to do that. Of course, one would imagine that these
ETFs being functions of, and publicly traded in the U.S., stock
markets are bound to have strong correlations with the U.S. markets
(read Three Hedge Fund ETFs for Uncorrelated Returns).
However, these ETFs prices move more or less in alignment to
their net asset value (NAV). Moreover, they also have a
substantially large asset base. Thus the authenticity of this high
correlation is more or less established.
In the modern investment era, investors are left with very
little choices of portfolio diversification, especially
international. Also, with increasing liberalization and
globalization there is every possibility that the increasing global
equity correlation may continue to surge in the near future,
providing even less scope for diversification and further
underscoring how globalized the economy has become in many
respects.
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ISHARS-AUSTRAL (EWA): ETF Research Reports
ISHARS-GERMANY (EWG): ETF Research Reports
ISHARS-UNITED K (EWU): ETF Research Reports
ISHARS-S KOREA (EWY): ETF Research Reports
ISHARS-BRAZIL (EWZ): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
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