Why Correlations Are 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 helped 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 two 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, with large countries (U.S. & Japan) with QE policies, 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 in the U.K., Switzerland, Germany, Sweden and Belgium have underperformed.
Fundamental Analysis Returning
From our perspective, the bifurcation within emerging markets 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 complemented by the country-specific impacts of the recent oil price collapse (oil importers versus oil exporters) and a few idiosyncratic/political developments in the U.K., Brazil, Mexico, India and France.
As we expect the “decreasing systematic risk and increasing idiosyncratic risk” regime to persist over the medium term, we anticipate an extended period of low country correlation. We recommend balanced multifactor analysis for country allocation decisions and currently prefer non-U.S. equities versus U.S. equities, and emerging market equities versus developed-market equities.
The author can be reached at [email protected].