All Together Now

A ripple in one market causes a tsunami in another. Are global markets getting too interconnected?
Rebecca McReynolds |  September 7, 2011
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Concerns over Greece’s solvency recently triggered a selloff in European bonds. That strengthened the dollar against the euro. As a result, US products are more expensive overseas, which could hurt US corporate profits.

Welcome to globalization.

Capital markets are so tightly connected now that even a seemingly isolated event can quickly become contagious. But a new study suggests that globalization may actually be the cure, not the problem.

The Ties that Bind

Geert Bekaert, a Chazen Senior Scholar and professor of finance and economics at Columbia Business School, argues that equity markets with tighter links to the global economy actually performed better than those with limited international exposure during the most recent global meltdown.

There is no doubt that the degree of correlation among international equity markets has increased in recent years, Bekaert says. And history shows that those correlations typically jump during financial crises as investor panic sets in. So, using the 2007-2009 crisis as a laboratory, Bekaert and co-authors Michael Ehrmann, Marcel Fratzscher, and Arnaud Mehl, all from the European Central Bank, looked for market movements that strayed outside those historical norms. They then determined where any excess movement, what they call “contagion,” originated.

Under the globalization theory, stocks and markets with the deepest international ties should have been the hardest hit, Bekaert says. But the study found just the opposite. In fact, the more globally connected a market was, the better it performed during the most recent meltdown. Yes, some of the contagion was generated by global influences, he says, but local factors had a much greater impact on how those markets performed. For example, the governments that stepped in quickly, including the United States and Germany, offering debt and deposit guarantees, were able to better insulate their equity markets and stabilized their economies faster.

“What really mattered was the underlying fundamentals of the local economy and how each government responded to the crisis,” says Bekaert.

The Takeaway

These results reject the globalization theory in favor of what Bekaert calls the “wake-up call” hypothesis. During bull markets, the rising tide really does lift all boats, he says, regardless of their seaworthiness. When things head south, though, investors tend to “wake up” to the importance of fundamentals, such as current account balances and political risk, and punish the companies and the local governments that don’t make the grade.

For investors rethinking their asset allocation strategies in the wake of the international crisis, Bekaert says that global diversification can still pay, despite today’s higher correlations. The secret is in understanding where the fundamental risks lie and balancing your portfolio accordingly.

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