By James Calhoun, Accuvest Global Advisors
Over the last 24 months, the average correlation between country equity markets has dropped significantly. These dropping country correlations are also clearly visible at the regional level.
As seen in the chart below, rolling 1 year correlations between the S&P500, EuroStoxx 600, Nikkei 225, and MSCI Emerging Markets Index are making new post-2000 lows. While inter-regional equity return correlations are almost always positive, how positive they are or aren’t affects how much value there is in regional and country level allocation decisions. Low country correlation is an investment opportunity for country selection.
Why were correlations so high?
Mathematically, correlations across countries (or securities) increase when systematic risk increases, or idiosyncratic risk decreases. A systematic risk is felt throughout the system; it is a “shared” risk, a “common denominator”. The 2007 to 2016 period of historically high correlations can be attributed to elevated systematic risk outweighing traditionally important country specific risk. Elevated systematic risk resulted in a “risk on – risk off” market environment where countries (regardless of risk, value, or fundamentals) moved in unison.
Mapping systematic risk to the chart above, we postulate that the 2007 to 2012 period of elevated correlations can be attributed to global financial crisis (2008-2009) and subsequent “shared” uncertainty surrounding the interest rate effects of quantitative easing starting with the U.S. in 2009, Bank of England Q.E. in 2010, and Bank of Japan Q.E. in 2010. The drop in rolling 1 year correlations during 2012 to 2013 can be mapped to the European debt crisis and U.S. taper tantrum, which had an acute impact on Europe and Emerging Markets, respectively. Regional correlations began increasing again when Mario Draghi re-affirmed the ECB’s willingness to “do whatever it takes” to save the Euro and the FED used forward guidance to emphasized a more cautious “lower for longer” approach to their Q.E. tapering.