With Draghi’s announcement, Europe joined the U.S. and Japan in synchronized quantitative easing, strengthening the “systematic” impact of low/negative interest rates on country correlations. This coordinated global central bank policy overwhelmed idiosyncratic country specific risks. Accordingly, countries with high risk, expensive valuations, and weak fundamentals surged and dipped in unison with countries exhibiting low risk, stronger fundamentals, and cheaper valuations – resulting in a period historically high country correlation.

Why are correlations dropping?

The key to lower country correlations is increasing idiosyncratic risk and decreasing systematic risk.  As the risks of deflation in Europe abated and global economic growth transitioned from recovery to expansion, expectations for normalization of monetary policy emerged. These expectations for the normalization of interest rate policy have help shift the global focus of investors from systematic risks to a more traditional fundamental analysis of country specific “idiosyncratic” risks.

Accuvest investment factor performance confirms that the focus of global investors (i.e. what the market is rewarding) has shifted over the last 2 years.  With this shift in investor focus, we have seen the composition of global equity returns transition from a long period of narrow stable leadership, large countries (US & Japan) with Q.E., to the current period of broader, but evolving, leadership from smaller countries (select Emerging Market and European countries leading single country performance).

Importantly, there is a bifurcation of returns within the Emerging and European segments of the global market. Specifically, Asia Pacific EM and Eastern Europe EM have done well while Latin America and India have lagged.  Similarly, within Europe, Austria, Poland, Denmark, Denmark, Italy, Spain, and France have outperformed while the U.K. Switzerland, Germany, Sweden, and Belgium have underperformed.  From our perspective, the bifurcation within EM and Europe can be attributed to fundamental analysis. Correlations have dropped as investors have begun delineating between countries that are fundamentally attractive and countries that are fundamentally unattractive.  This is at the heart of the recent drop in country correlation.  This return to traditional country specific fundamental analysis has been complimented by the country specific impacts of the recent oil price collapse (oil importers vs. oil exporters) and a few idiosyncratic/political developments in the U.K., Brazil, Mexico, India, and France.

What do this mean for your global equity portfolio?

As we expect the “decreasing systematic risk & increasing idiosyncratic risk” regime to persist over the medium term, we anticipate an extended period of low country correlation. We recommend balanced multi-factor analysis for country allocation decisions and currently prefer non-US equities vs. US equities and EM equities vs. DM equities.

This article was written by James Calhoun of Accuvest Global Advisors, a participant in the ETF Strategist Channel.