An understanding of the magnitude and dynamics of return correlations among global stock markets is critical for a sound global asset management programme. How low these correlations are among diverse markets, of course, confines the potential benefits to global investors of portfolio risk diversification strategies. But, knowing how they vary over time can also be an imperative element of a flourishing strategic or tactical global asset allocation program.

Studies attempted to understand the factors underlying the low international correlations by focusing on institutional factors and, specifically, the fact that national market indexes have a very different industrial composition. Nevertheless, risk diversification by investing in the Australian and Canadian market for US investors may not stem from their economic growth rates, monetary/fiscal policies or exchange rate movements, but from the fact that they are heavily resource-based markets. The early evidence had plainly documented that country factors were more important than industry factors, but the debate was sparked again in the 1990s by a series of research that re-established the mounting significance of industry factors. No doubt this is an intuitive outcome with the growing integration of international equity markets through the growth in cross-border listings, international mutual and closed-end country funds and the introduction of new currency blocs.

Correlations in international equity returns are unstable over time. Important contributions have established that these correlations dynamics have interesting regularities, such as slowly autoregressive patterns at the monthly and even intraday frequencies. What these studies have been less successful in uncovering is a systematic pattern that relates closely to economic fundamentals, such as changes in interest rates, dividend yields, exchange rate changes, capital flows, liquidity and macroeconomic factors. The inability of these fundamental factors to capture the time-variation in equity correlations has led some to question whether behavioural forces, like contagion effects, play a role.

Numerous recent studies have revealed that the instability in international equity correlations is associated with periods of high stock market volatility and, particularly, during bearish market volatility. This threshold effect (higher correlations with larger returns) and asymmetric effect (higher correlations with large negative or bad-news returns) is fundamental for investors as it implies that the benefits of the safety net of international diversification are lost when it is needed most.

Could the magnitude and dynamics of correlations reflect contagion effects? Those fundamental factors are only dimly linked to these dynamics and that these extreme, asymmetric patterns exist has led experts to suggest that contagion, rational or irrational, can be the only remaining explanation. “Contagion, in general, is used to refer to the spread of market disturbances, mostly on the downside, from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads and capital flows.”

Some researchers caution that inferences about contagion effects from time-varying correlations may be blemished because of natural statistical biases due to time-varying volatilities, omitted variables and endogeneity. Still others propose a new framework of analysis for contagion that draws on co-incidences of extreme returns in international markets, but more importantly, explicitly does not draw on traditional measures of stock return correlations. Their results also suggest that their measures of international financial contagion may not be as large as what others may have perceived. Until researchers get a better handle on the economic importance of global stock returns correlations and, especially, the association with contagion, caution is advised. Stay tuned.

<B>Nitish BENIMADHU</B>