One reason why investors clamour for international stock exposure has traditionally been the belief that foreign stocks are reasonably uncorrelated from our home market. The theory is that stock markets in different countries will tend to move in different directions at different times. So if the UK market has a period of bad performance, perhaps German, Japanese, or Chinese stocks will be doing better. Over time, this diversification could help smooth out returns and provide better long-term returns with less risk.
But is this view accurate anymore? Are investors really gaining diversification when they look abroad? We looked at the difference in correlation between various international indexes to examine what kind of changes have happened during the last 15 years. Our top-level findings were that correlations, especially in emerging markets, have risen markedly during the time period.
The indexes that we tested were:
MSCI All-World ex-U.S.: Tracks a broad cross section of large- and mid-cap stocks from everywhere in the world except the United States.
FTSE 100: Tracks 100 of the largest stocks traded in the United Kingdom.
MSCI EMU: Tracks large- and mid-cap stocks from countries that use the euro.
S&P Latin America 40: A concentrated portfolio of 40 Latin American stocks.
Nikkei 225: Tracks 225 of the largest stocks traded in Tokyo.
MSCI Pacific ex-Japan: Predominantly tracks the markets of Australia, Hong Kong, and Singapore. It does not include Japanese or mainland Chinese stocks.
S&P China BMI: Tracks the universe of firms with predominantly Chinese operations that are available to foreign investors.
MSCI BRIC: Tracks 200 stocks in the BRIC markets (Brazil, Russia, India, and China).
A few caveats before we get to the data. This is far from a definitive study of the issue. The choice of indexes and time periods has an effect on results, as do other issues such as index consecution and currency. However, we think the data does provide a good top-level look at how things have changed over time.
During the last 15 years (as shown above), correlation coefficients, especially in the emerging markets, have been reasonably low. A correlation coefficient of 1 would imply perfect correlation with indexes moving in lock step together, while 0 means that there is no relationship between the two indexes. Of our sample, China has been the least correlated with the FTSE 100 with a coefficient of 0.39, the Nikkei 225 coming in next at 0.58, and the BRIC index coming in third at 0.66.
When we compress the time period to only the last five years (as shown above) the changes become readily apparent. The coefficient for China jumps up to 0.74, and the BRIC index coefficient rises to 0.80.
When evaluating only the most recent year (as shown above), we find that emerging markets have paralleled UK and developed markets more closely than they have during the last 15 years.
Why The Numbers Have Changed
So has increasing market correlation over the last 15 years debunked the theory that investing abroad is a good diversifier? To answer this question, we need to consider some reasons why these numbers have moved.
The first is simply that large corporations have become increasingly more globalised over the last 15 years. Newly open economies and a quest for growth has given firms in developed markets the incentive to do more business abroad. Companies in developing markets are also making inroads in developed countries. The cross-pollination of revenue sources makes firms in all countries more dependent on the global economy and not just the economy in their home countries. So a downturn almost anywhere in the world is going to have an impact on the earnings of almost all big firms, regardless of their home base.
This effect is made more prominent in the numbers displayed on the charts by the fact that most major indexes tend to be loaded with large-cap names to the exclusion of smaller stocks. It is these smaller companies that are likely to be pure plays on the local economy leaving the indexes heavily weighted to larger, more globalised firms.
Another key factor to the high levels of correlation has been the financial crisis. The credit crunch and subsequent economic slowdown was a truly global event; there were few corners of the economy in any country that didn't feel the impact. This means that markets everywhere sold off in huge numbers at the beginning of the crisis, and when the smoke cleared, they all came back in a big way.
The Future Direction of Correlations
Is this higher level of correlation permanent? There is no way to give a definitive answer, but it seems likely that correlations will remain higher than historical averages even if they fall from today's levels.
First off, interconnectedness is here to stay. Without question China will see more impressive growth than the UK during the next 10 years, but at the same time UK firms are growing in China and participating in that growth. This will help further link the prospects of shares in both regions.
And despite talk of the decoupling of fast-growing emerging markets from the slow-growth developed world, the recession showed that developing nations still rely heavily on exports to the developed world. This reliance will diminish as the consumer market in developing countries picks up. All else equal, we would expect this to force correlations lower.
An additional factor that should reduce correlations somewhat going forward is that as the recovery progresses, there will be more separation between markets. Despite globalisation, many stocks' fortunes are still tied closely to their local markets. As the fog of credit crisis clears and the gulf between the high-performing markets and laggards expands, we would expect performance to eventually follow. That said, correlations should still remain higher than past levels.
The data shows that even though different local economies around the world are growing at vastly different rates, the large multinationals that most investors buy are becoming increasingly interconnected. This has and will continue to make it more difficult to construct an international portfolio that provides true diversification.
But just because correlations have increased, doesn't mean that investors shouldn't look abroad. One of the strongest reasons to invest internationally has nothing to do with correlation. It is that the UK doesn't have a monopoly on firms with strong competitive advantages that are trading at a discount. Correlation coefficients say nothing about valuation, so there could always be opportunities for individual investors and fund managers alike to find some cheaper gems.
The original version of this article was published on Morningstar.com, a sister site to Morningstar.co.uk.
