This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by James Calhoun, portfolio manager at Accuvest Global Advisors in Walnut Creek, California.
Over the last 24 months, the average correlation between single-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 one-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 Correlations Were 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 2007-2016 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 2007-2012 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 in 2010 and Bank of Japan in 2010.
Country-Specific Risks Overshadowed
The drop in rolling one-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 ECB Chairman Mario Draghi reaffirmed the ECB’s willingness to “do whatever it takes” to save the euro, and the Fed used forward guidance to emphasize a more cautious “lower for longer” approach to its QE tapering.
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 of historically high country correlation.
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].