Global equity correlation - Driven by common factors

International equity markets seem to be increasing synchronized, that is, the return correlations across global markets have increased and diversification has gone down. Researchers have suggested two lines of thinking that drive this increase: one, a common factor or set of macro factors that move together, and two,  the economic or financial linkage between countries, spatial relationships.

Researchers have found that accounting for both factors will improve our understanding of global equity correlation. The common factor has been explored by several researchers who have suggested that there is a common risk factor associated with increased global volatility and a common financial factors which is associated with US monetary policy. An increase in risk will change risk appetites and lead to lower returns across all equity markets. An increase in US interest rates which tightens global credit will also have a negative impact across many global equity markets. 

The spatial relationship accounts for the integration of markets that will create higher correlation. There are financial and economic blocks which support higher correlation among equity markets. Global equity indices will still be driven by real GDP and real interest rates associated with the home country.

 

Once the common factor is identified within returns, there can be macro features which can be linked with the common factor. See the paper, "Assessing the international comovement of equity returns", which attempts to measure the common factor and the spatial factors in one model. They find that the common factor will have greater impact for open economies and more rigid exchange systems. 

If you are going to include international equity indices within a global macro framework, it is critical to measure and assess these common factor themes and not think about these equity markets in isolation. Even for following trends, it is important to track international common factors to distinguish between the equity index trend and a common trend across global equity markets. If the driver a common trend, then there is less diversification across positions.