Download The Global Recession and International Investing

The Global Recession and
International Investing
Vanguard Investment Counseling & Research
Executive summary. The global economy is grappling with the most severe
financial shock since the Great Depression. Indicative of the magnitude of the
shock, equity market volatility is at or near unprecedented levels, corporate bond
yields are extremely high relative to U.S. Treasury yields, and commodity and
equity prices have plummeted. With the global financial system deleveraging
and the U.S. economy in the midst of a severe recession, the global economy
is decelerating quickly after years of heady growth.
These profound recent developments raise important longer-term questions
with respect to the world economy and global financial markets. In this paper,
we address several related questions:
• Given the increased linkages among financial markets, trading partners, and
capital flows around the world, how synchronized is the global economy?
• Has the global business cycle become less sensitive to the U.S. economy
over time? Is the United States still the “locomotive” that drives world
economic growth?
• Have emerging markets “decoupled” from the rest of the world? Can the
explosive growth of the so-called BRIC (Brazil, Russia, India, and China)
economies counteract recessions in developed markets?
• How do changes in the global business cycle affect the diversification
benefits of international investing? Is global diversification at risk?
1 We would like to thank Lindsay Fay and Julieann Shanahan for excellent research assistance.
Connect with Vanguard > www.vanguard.com
Authors1
Joseph H. Davis, Ph.D.
Roger Aliaga-Díaz, Ph.D.
We find that—despite more integrated trade and financial linkages around the
world—the global business cycle accounts for only approximately 50%–60% of
the variation in real GDP growth across the major developed and emerging market
economies. The remaining economic volatility is a result of region-specific and
country-specific factors. Of course, the correlation among international business
cycles varies over time, by country, and by the source and magnitude of financial
shocks. Broadly speaking, cross-country correlations in real GDP growth rise
whenever (1) asset-price shocks are systemic (e.g., the 1970s oil-price shock)
and (2) the world’s largest economies are severely impaired in the process
(e.g., the situation in the United States today).
We further show that the U.S. economy remains the primary accelerator of
world economic growth, even though the BRIC economies have clearly emerged
as another important engine. Based on this and other factors, emerging market
economies remain fully coupled to severe U.S. recessions and global financial
crises. In more normalized conditions, the economic correlations between
emerging markets and developed markets tend to be lower than businesscycle correlations among industrialized countries.
Finally, we document the well-recognized pattern that short-run correlations
among international equity markets tend to be asymmetric: Correlations rise
dramatically during global financial crises. However, this stylized fact does not
invalidate the benefits of global equity diversification. Indeed, the diversification
benefits of international investing are most apparent once financial crises
subside, given the heterogeneous economic structures, capital-flow sensitivities,
commodity-price exposures, and varied monetary and fiscal policy responses
of countries around the world. The expected secular reduction in the world
economy’s reliance on the U.S. consumer should also contribute to lowerthan-present international equity correlations over the following decade.
Notes on risk: Investments are subject to risk. Foreign investing involves additional risks including
currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally
more risky than stocks of companies in developed countries.
Diversification does not ensure a profit or protect against a loss in a declining market.
Past performance is not a guarantee of future results. The performance of an index is not an exact
representation of any particular investment, as you cannot invest directly in an index.
2 > Vanguard Investment Counseling & Research
Introduction
The global economy is grappling with the most
severe financial shock since the Great Depression.
Financial market volatility is at or near unprecedented
levels; yields on corporate, sovereign, and high-yield
bonds have spiked; and global equity and commodity
prices have plummeted. As illustrated in Figure 1,
financial markets around the world are under
considerable stress. Figure 1 clearly indicates not
only the magnitude of this extraordinary financial
shock, but also how integrated international financial
markets have become.
Policymakers around the world have taken
unprecedented and coordinated action to address
the financial panic. In the United States, the Federal
Reserve Board has slashed short-term interest rates
aggressively, has created an array of novel liquidity
facilities, and has drastically expanded its balance
sheet to provide an unprecedented amount of
liquidity to the impaired financial system. At the
same time, the U.S. Treasury has used public funds
to implement a number of extraordinary steps,
including the injection of capital into certain
financial institutions.
Figure 2. A long U.S. recession
Duration of recessions, in months, 1945–present
22
20
18
Figure 1. A profound global financial shock
Percentage of countries experiencing financial stress
(1980–2008)
100%
80
1987 crash
Scandinavian
banking crisis
LTCM* collapse
60
40
20
0
1980
1985
1990
1995
2000
2005
*Long-Term Capital Management.
Source: International Monetary Fund (IMF).
Despite these policy actions, the U.S. economy
is expected to contract significantly at the end of
2008 and well into 2009 as a result of the financial
crisis. The extreme financial shock has significantly
tightened the supply and increased
the costs of credit for consumers,
businesses, and other institutions.
According to the Vanguard Economic
Strategy Group, the duration of the
current U.S. recession will likely be
the longest of the post-World War II
era (see Figure 2).
16
Months
14
12
10
8
6
4
2
0
1945 1948/49 1953/54 1957/58 1960/61 1969/70 1973/75 1980 1981/82 1990/91 2001 2008/09
With the global financial system
deleveraging and the U.S. economy
facing a severe recession, the global
economy is decelerating quickly after
years of heady growth. These profound
recent developments raise important
questions about the world economy
and global financial markets.
Note: Values for 2008–2009 reflect a forecast by Vanguard Economic Strategy Group.
Sources: Vanguard Economic Strategy Group, National Bureau of Economic Research.
Vanguard Investment Counseling & Research > 3
Most obviously, how sensitive is the
global economy to the U.S. business
cycle? As shown in Figure 3, past U.S.
recessions have either coincided with—
or led to—global slowdowns because
the rest of the world’s trade and financial
markets are linked with those of the
United States. Should investors expect
the U.S. economy to continue to act as
the proverbial “locomotive” for world
growth in the years ahead?
Figure 3. The U.S. economy and the rest of the world
Real GDP per capita growth rates for the United States
and the rest of the world, 1951–2008
8%
6
4
2
0
–2
–4
1951
1958
1965
1972
1979
NBER U.S. recession
1986
1993
United States
2000
Rest of the world
Sources: International Monetary Fund and Vanguard Economic Strategy Group.
Figure 4. The emerging markets as a rising
global economic force
2007
Some analysts believe that the world
economy has become less sensitive
to U.S. developments as a result of
rapid growth in emerging markets.
Indeed, Figure 4 highlights the growing
and outsized contribution of emerging
market economies to recent worldwide
economic growth. In light of explosive
growth in the so-called BRIC economies
(Brazil, Russia, India, and China), many
analysts wonder whether the emerging
markets have “decoupled” from the
rest of the world.
Contribution to world real GDP growth
As Figure 5 illustrates, as these economies have
become more integrated with (and a more prominent
share of) the world economy, the correlation of their
business cycles to real GDP growth in the rest of
world has increased. Do these rising correlations
reflect a greater risk of global economic contagion,
or do they suggest that the explosive growth of the
BRIC economies can help to counteract recessions
in developed markets?
3.0
Percentage points
2.5
2.0
1.5
1.0
0.5
0
1970s
average
1980s
average
1990s
average
Developed markets
2000–2007
Emerging markets
Note: GDP data in this figure are defined on a purchasing power
parity basis.
Source: International Monetary Fund and Vanguard Economic
Strategy Group.
4 > Vanguard Investment Counseling & Research
In terms of portfolio construction, how have
changes in the global business cycle affected the
diversification benefits of international investing?
Is global diversification at risk? What are reasonable
expectations for the correlations between U.S. and
international equity returns in the years ahead?
We address each of these questions in turn.
Figure 5. Correlations of the U.S. and BRIC
economies with the rest of the world
Rolling 20-year correlations in real per-capita GDP growth
0.8
0.6
Correlation
0.4
0.2
0
–0.2
Business cycles in the developed markets have
historically been the most highly correlated with
the global business cycle by definition, since
developed markets represent a large share of the
world’s total economic output. Between 1950 and
2007, the contemporaneous correlation in annual
real GDP growth between the developed markets
and the world economy has been 74%. Over that
same time period, the collective emerging market
economy has had a 39% contemporaneous
correlation with the world economy. Generally
speaking, the economic correlations between
emerging markets and developed markets have
tended to be lower than business-cycle correlations
among industrialized countries.
–0.4
1970
1975
1980
1985
1990
1995
2000
2005
United States and the rest of the world
BRICs and the rest of the world
Notes: The “rest of the world” excludes only the United States
for the correlations with the United States, and excludes only the
BRIC economies for the correlations with the BRICs.
The effects of globalization:
Convergence or decoupling over time?
Given the dramatic changes in the global economy
over the past several decades, how have the
correlations among international business cycles
changed through time?
Source: See the Appendix for an explanation of the data sources.
The global business cycle
Over the past five decades, the average correlation
among the world’s major economic blocks has been
positive, but far from perfect. On average, the global
business cycle has accounted for approximately
50%–60% of the variation in real GDP growth across
the major developed and emerging market economies
since 1950.2 The remaining 40%–50% of the
economic variation observed across the four major
economic regions has been associated with regionspecific and country-specific factors, such as whether
a country is a commodity exporter or importer and
its level of reliance on international capital flows.
Conventional wisdom would suggest that the
forces of globalization have led to a convergence
in national business cycles and an increased risk
for financial spillovers, or “contagion.” Economies
around the world have generally become more
integrated through the linkages of trade, finance,
and banking. Statistics from the International
Monetary Fund (IMF) show that the ratio of world
trade to world GDP has nearly doubled over the
past three decades, while the gross external assets
of developed and emerging markets have risen
exponentially over the same period.
2 These values represent the percentage of the fluctuations in annual real GDP per capita growth rates that are common across four economic regions (developed
North America, developed Europe, developed Asia, and emerging markets) as derived from a dynamic factor model.
Vanguard Investment Counseling & Research > 5
Figure 6. Are emerging markets coupled to developed markets?
Arguments in favor of decoupling
Arguments against decoupling
Decline in relative reliance on U.S. export market.
Increase in total trade with developed markets.
Increased share of trade within regions.
Emerging markets very export-oriented.
High BRIC economic growth rates.
United States remains the largest import market.
Emerging markets financial market depth less than that of developed markets.
Reliance on foreign investment and capital flows.
General improvement in fiscal balances.
Global financial integration.
Financial market spillovers/contagion.
High commodity-price exposure or dependence.
At the same time, the process of globalization
has been accompanied by several structural changes
in the world economy that have contributed to a
less U.S.-centric global economy. Most importantly,
intraregional trade has grown relative to traditional
trade links between emerging economies and the
developed world. The impressive performance of
some emerging countries has led to a greater
diversification of trade destinations, as emerging
economies have begun to trade more often with
each other.
Some analysts argue that the developments in
the emerging markets have been so drastic that
the emerging markets have decoupled from the
rest of the world. According to the decoupling
hypothesis, the emerging market business
cycle is now unaffected by U.S. economic growth.
However, Figure 6 delineates a number of arguments
that would run counter to the emerging-market
decoupling hypothesis. The relative decline in trade
linkages of emerging markets with the United States,
for instance, must be weighed against increased
financial linkages with developed markets.
6 > Vanguard Investment Counseling & Research
How closely do developed and emerging
markets now move together?
To investigate the countervailing forces of global
integration and decoupling, Figure 7 shows the
correlations in real economic activity between the
developed and emerging economies over a rolling
10-year period. Figure 7 reveals two stylized facts.
First, there has been only a modest rise in correlations
between developed and emerging market business
cycles since the 1950s. This observation is consistent
with the results of several studies, including Stock
and Watson (2005), which have found minimal
evidence of increased international synchronization
of business cycles, despite increases in international
trade flows, integration of developed markets, and
the introduction of the euro.
The second obvious pattern of Figure 7 is that
correlations in international business cycles vary
meaningfully over time. Indeed, the time-varying
correlations underscore the important role that
systemic asset-price shocks (i.e., “contagion”
or “terms-of-trade” shocks) can have on the
co-movement of international business cycles.
For example, the massive oil-price shocks of the
mid-1970s and early 1980s (and their economic
and inflationary fallout) formed a primary channel
through which international business cycles moved
more in tandem during that period (Kose, Otrok,
and Prasad, 2008). Most recently, co-movement
has risen following the bursting of the global IT
bubble in 2000, the ensuing global slowdown,
the subsequent global economic boom, and the
recent financial crisis.
Figure 7. The time-varying correlations between
the developed and emerging economies
Ten-year rolling correlations for real per-capita
GDP growth, 1951–2007
1.00
0.75
0.50
Correlation
Conversely, correlations among developed and
emerging economies turned negative during
the 1990s, since many economic shocks did not
engender global systemic crises. For instance,
the savings and loan crisis in the United States
and Japan’s “lost decade” during the 1990s
remained more localized, thereby having a
more subdued influence on other countries.
0.25
0
–0.25
–0.50
–0.75
Is the United States still the locomotive
of the world economy?
Correlations among global business cycles also
rise significantly when financial shocks severely
impair the world’s largest economies through the
secondary “spillover” channel. Past U.S. recessions
have most adversely affected the broader global
economy through two primary links: trade (the
United States is the largest importer of foreign
goods in the world) and finance (U.S. financial
markets are the core of the global financial system).
Forbes and Chinn (2003), for instance, show that
the performance of the U.S. equity market tends
to significantly affect the returns of most global
markets, rather than vice versa.
Given the aforementioned changes in the global
economic landscape, how sensitive is the global
economy to the U.S. business cycle? In an attempt
to isolate the causality effects of the secondary
“spillover” channel from the high contemporaneous
correlations observed through the primary “contagion”
channel, we have estimated a growth accelerator
model for the global business cycle. Specifically, the
model is designed to quantify how much the rest of
the world’s real GDP growth will change next year
–1.00
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Sources: Authors’ calculations, based on data sources listed in
the Appendix.
given the relative growth-rate differential between
the United States and the rest of the world this year.
We estimate this model over different time periods
and include the BRIC economies as well.
Figure 8, on page 8, presents the estimated growth
accelerator effects for both the U.S. and the BRIC
economies over the most recent 20-year period and
the previous 20 years. The estimated coefficients in
Figure 8 show that the U.S. economy remains the
primary driver of world economic growth, although
the BRIC economies have clearly emerged as a
secondary locomotive. Since 1990, for instance,
economic growth in the rest of the world has
accelerated on average 0.25% whenever the growthrate differential between the United States and the
rest of the world widened by 1 percentage point the
previous year. By comparison, the growth multiplier
effect of the BRICs on the rest of the world is
currently 0.20%, a notable rise from virtually zero
a generation ago.
Vanguard Investment Counseling & Research > 7
The implications for international investing
Figure 8. U.S. economy remains the primary
locomotive, although BRICs’ role is rising
Multiplier effect (in bps) on
rest-of-world real GDP growth
0.30
0.25
0.20
0.15
0.10
0.05
As trade barriers have subsided, large inter-country
trading blocs have emerged, and financial market
restrictions have relaxed, world equity markets have
become increasingly integrated. This has led to rising
equity market correlations, a fact well documented
by Vanguard research.3 The global financial crisis of
2008 has led to even higher correlations as stock
markets around the world have fallen markedly in
value. These recent events may tempt investors,
as they have in the past, to conclude that the longterm case for international investing—portfolio
diversification—is invalid.
0
U.S.
BRIC
Previous 20 years (1969–1988)
Last 20 years (1989–2008)
Notes: The values in the figure for the United States
represent the estimated regression coefficients (β )
of the following equation: Δ World GDP real growth
ex-USt = α + β (US real GDP growtht–1 – World real GDP
growth ex USt–1) + δ (Δ World GDP real growth ex-USt–1) +
φ (Δ World real GDP growth ex-USt–2) + εt. Similarly, the
values in the figure for the BRICs represent the estimated
regression coefficients (β) of the equation: Δ World GDP
real growth ex-BRICt = α + β (BRIC real GDP growtht–1 –
World real GDP growth ex BRICt–1) + δ(Δ World GDP
real growth ex-BRICt–1) + φ (Δ World real GDP growth
ex-BRICt–2) + εt .
Source: Vanguard Economic Strategy Group calculations,
based on data as discussed in the Appendix.
Taken together, Figures 7 and 8 indicate that
emerging market decoupling is unlikely in global
financial crises because economic growth in
the BRIC economies would have to accelerate
significantly to counteract recessions in developed
markets. As a result, emerging market economies
remain coupled to severe U.S. recessions and
global financial crises.
To be sure, the long-term diversification benefits of
international investing can be obscured by short-term
economic and financial factors such as bear markets,
financial crises, and recessions. Indeed, Figures 9 and
10 document the well-recognized pattern that shortrun correlations among international equity markets
tend to be asymmetric: correlations across national
stock markets are higher when the U.S. stock market
declines significantly (Figure 9), and when the U.S.
economy is in recession (Figure 10).
Figure 9 illustrates that when there is a bear market
in U.S. stocks, other markets tend to experience bear
markets as well, increasing the correlation between
markets. Tokat (2006) shows that since the early
1970s more than 70% of developed countries have
experienced bear markets in stocks simultaneously
with a U.S. bear market. The high international stock
market correlations during U.S. bear markets help
to explain why global contractions tend to be more
highly synchronized across countries than global
expansions.
3 See, for instance, recent Vanguard research papers by Philips (2008), Labarge (2008), and Tokat (2006).
8 > Vanguard Investment Counseling & Research
Figure 9. Stock market correlations are asymmetric
Correlations of monthly returns between the U.S. and
global markets, January 1970–October 2008
Figure 10. International diversification benefits
decline during U.S. recessions
Correlations of monthly returns between the U.S. and
global markets, January 1970–October 2008
0.8
0.65
0.60
Correlation
Correlation
0.6
0.4
0.55
0.2
0
Emerging
Pacific
Europe
World
U.S. stock return down more than 1 standard deviation
from historical average
U.S. stock return within 1 standard deviation from
historical average
U.S. stock return up more than 1 standard deviation
from historical average
Note: Global markets are represented by MSCI World, MSCI
Europe, MSCI Pacific, and MSCI Emerging Market Indexes. Based
on monthly returns over the period 1970–2008 (1988–2008 for
MSCI Emerging Markets Index).
Source: Vanguard Economic Strategy Group calculations based on
MSCI data, via Thomson Datastream.
The higher short-term correlation between U.S. and
international stock markets may seem to weaken
the case for international investing, validating the
oft-heard complaint that “diversification disappears
when you need it most.” We stress, however, that
this stylized fact does not invalidate the long-term
benefits of global equity diversification. For instance,
Figure 9 shows that even during U.S. “tail events”
(such as when the monthly return on the U.S. stock
market is down more than one standard deviation
from its historical average), international equity
market correlations with the United States do not
0.50
U.S. economic
recessions
U.S. economic
expansions
Source: Vanguard Economic Strategy Group calculations based
on data from MSCI, Thomson Datastream, and the National
Bureau of Economic Research.
equal 100%, on average. A good example is the case
of a worldwide commodity-price shock because of
falling oil supplies. While an oil-price shock will tend
to adversely impact the markets for industrialized
(commodity-importing) countries, such an oil shock
may benefit (on a relative basis) certain commodityproducing countries.4
Most importantly, Figures 9 and 10 reveal that the
diversification benefits of international investing
are most apparent once stock market volatility
subsides and recessions end. Indeed, as financial
crises subside, the economic and financial market
performance of countries will differ because of their
heterogeneous economic structures, capital-flow
sensitivities, commodity-price exposures, and
varied monetary and fiscal policy responses to
crisis events.
4 See the sidebar on page 11 for a deeper discussion of the relationship between commodity prices and emerging markets.
Vanguard Investment Counseling & Research > 9
Figure 11. Past and expected future correlations between the U.S. and international stock markets
Rolling 10-year window
0.95
0.85
Correlation
0.75
0.65
0.55
0.45
0.35
Jan.
1980
Jan.
1982
Jan.
1984
Jan.
1986
Jan.
1988
Jan.
1990
History
Jan.
1992
Jan.
1994
Jan.
1996
25th percentile
Jan.
1998
Jan.
2000
Jan.
2002
Jan.
2004
Jan.
2006
Jan.
2008
Median
Jan.
2010
Jan.
2012
Jan.
2014
Jan.
2016
Jan.
2018
75th percentile
Note: The figure represents the correlation between domestic equities (MSCI US Broad Market Index) and international equities (MSCI EAFE +
EM Index Gross). After October 2008, moving correlations are based on 10,000 simulation paths for domestic and international equity returns from
the Vanguard Capital Markets Model. Results may vary with each use and over time.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various
investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Source: Vanguard simulations based on the Vanguard Capital Markets Model and MSCI data via Thomson Datastream.
To illustrate this point, Figure 11 presents the
past and expected future rolling 10-year correlations
of monthly stock market returns between the U.S.
markets and a broad international index. The expected
future distribution of U.S.–international stock market
correlations is derived from the Vanguard Capital
Markets Model (VCMM).5 These estimates of future
long-term correlations are based in part on the
historical record and in part on reasonable assumptions about the likely course of global economic and
financial integration. Historical evidence suggests
that the financial and economic integration of different
regions—through trade and financial flows—increases
the correlation between these regions’ financial
markets and economies (Bekaert and Harvey, 2000).
Figure 11 shows that global correlations over
the next 10 years are expected to more closely
resemble those observed in recent years, rather
than the lower correlations observed in the 1970s
and 1980s. That said, the simulations indicate that
the correlations between the U.S. and international
equity markets are likely to decline from their
currently elevated levels over the next 10 years
as stock market volatility gradually wanes and the
financial crisis eventually passes. Secular global
economic developments that will alter interregional
and intraregional trade patterns should also contribute
to lower-than-present international equity correlations
over the following decade. Among the expected
developments are a reduced reliance on the U.S.
consumer to drive the world’s economy and a
gradual shift in focus within emerging market
economies from export-led growth to economic
expansion fueled by internal consumption demand.
5 The VCMM simulates returns and volatilities for a wide array of asset classes by implementing regression-based Monte Carlo methods. Asset returns
are modeled and then simulated based on their relationship to valuation, economic, fixed income, and global risk factors. For each asset class, the VCMM
creates 10,000 possible paths for these risk factors, then computes the implied asset returns and volatilities. For further details on the VCMM, see Wallick,
Aliaga-Díaz, and Davis (2008).
10 > Vanguard Investment Counseling & Research
Commodity prices and emerging markets
Over the past several years, commodity prices rose
and fell dramatically with changes in the commodity
demands of the BRIC economies, among other
factors (see Figure 12).6 These recent events have
raised important questions about the sensitivity of
emerging market economies and their stock markets
to movements in commodity prices.
Figure 13, on page 12, presents the average
correlation of emerging and developed markets
with changes in commodity prices, measured here
as the total return on the S&P GSCI Commodity
Total Return Index. Broadly speaking, emerging
markets tend to correlate more positively with
commodity prices than do developed markets
(i.e., EAFE countries or the United States). This
is not surprising, since emerging markets tend
to be more commodity-intensive than developed
markets and are generally net commodity exporters.
Perhaps more surprising is the fact that the average
economic and financial correlation of emerging
markets with commodity prices in Figure 13 is fairly
low. Since 1988, the average monthly correlation
between the GSCI Commodity Total Return Index
and the stock market return on the MSCI Emerging
Markets Index has been approximately 19%.
The positive-but-low correlations between
commodity prices and emerging market stock
returns can be explained by a number of factors,
including the relative importance of supply, demand,
currency fluctuations, and other factors that may
influence commodity prices at any given time (Davis
and Aliaga-Diaz, 2008). Over the past several years,
for instance, the correlations between emerging
markets and commodity prices have been higher
than those indicated in Figure 13 because of changes
in the commodity demands of the BRIC economies.
Figure 12. Global commodity demand and GSCI commodity investment returns
Both series indexed to 100 in December 1990 and reflect data through November 2008
500
800
700
400
600
500
300
400
200
300
200
100
100
0
0
Dec.
1990
Dec.
1992
Dec.
1994
Dec.
1996
Baltic Dry Cargo Index (left axis)
Dec.
1998
Dec.
2000
Dec.
2002
Dec.
2004
Dec.
2006
Dec.
2008
GSCI Total Return Index (right axis)
Note: The Baltic Dry Cargo Index measures transatlantic shipping prices and serves as a proxy for global commodity demand.
Sources: Bloomberg, Thomson Datastream, Economy.com, and Vanguard Economic Strategy Group calculations.
6 See Davis and Aliaga-Díaz (2008) for more details on the Baltic Dry Cargo Index and the influence of global demand and other factors on oil prices.
Vanguard Investment Counseling & Research > 11
Figure 13. The average correlation of commodities
with developed and emerging markets, 1988–2008
Emerging
EAFE*
U.S.
Correlations with real GDP growth (annual data)
GSCI, all commodities
0.43
0.25
0.30
Correlations with stock market returns (monthly data)
GSCI, all commodities
0.19
0.15
0.04
GSCI, agricultural and livestock
0.24
0.14
0.17
GSCI, grains
0.22
0.11
0.17
GSCI, industrial metals
0.29
0.28
0.22
GSCI, precious metals
0.18
0.18
–0.06
GSCI, petroleum
0.15
0.09
–0.02
GSCI, energy
0.12
0.10
–0.02
Overall, Figure 13 is a reminder that stock returns
on a broad emerging market index are not driven
solely by changes in commodity prices. Moreover,
the relationship between commodity prices and
stock prices varies significantly across individual
emerging markets, depending on their own
commodity intensity and relative terms of trade
(the ratio of commodity export prices to import
prices). The monthly returns on the MSCI Chile
Stock Index, for instance, are highly correlated
with copper prices (Chile is a prominent exporter
of copper), yet are virtually uncorrelated with oil
prices (Chile is a net importer of oil).
Notes: EAFE includes developed countries in Europe, Australasia, and
the Far East. Monthly stock market returns are based on the MSCI Total
Return Index. Commodities are based on the S&P GSCI Commodity Total
Return Index. Real GDP growth data at annual frequency (see the Appendix
for details).
The financial crisis that first erupted in the U.S.
subprime mortgage market in August 2007 has
evolved into the largest financial shock since the
Great Depression, inflicting heavy damage on
markets and institutions around the world. Indicative
of the magnitude of the shock, equity market volatility
is at or near unprecedented levels, corporate bond
yields are extremely high relative to U.S. Treasury
yields, and commodity prices have plummeted.
With the global financial system deleveraging and
the U.S. economy in the midst of a severe recession,
the global economy is decelerating quickly after
years of heady growth.
global business cycle accounts for only approximately 50%–60% of the volatility in real GDP
growth across the major developed and emerging
market economies. The remaining economic volatility
is a result of region-specific and country-specific
factors. Of course, the correlation among international
business cycles varies over time, by country, and
by the source and magnitude of financial shocks.
Broadly speaking, cross-country correlations in real
GDP growth rise whenever (1) asset-price shocks
are systemic (e.g., the 1970s oil-price shock) and
(2) the world’s largest economies are severely
impaired in the process (e.g., the situation in the
United States today).
These profound recent developments raise
important longer-term questions with respect to
the world economy and global financial markets.
In this paper, we find that—despite more integrated
trade and financial linkages around the world—the
We further show that the U.S. economy remains the
primary accelerator of world economic growth, even
though the BRIC economies have clearly emerged
as an important factor. As a result, emerging market
economies remain fully coupled to severe U.S.
Conclusions
12 > Vanguard Investment Counseling & Research
recessions and global financial crises. In more
normal conditions, the economic correlations
between emerging markets and developed markets
tend to be lower than the business-cycle correlations
among industrialized countries.
Finally, we document the well-recognized pattern
that short-run correlations among international equity
markets tend to be asymmetric: correlations rise
dramatically during global financial crises. However,
this stylized fact does not invalidate the benefits of
global equity diversification. Indeed, the diversification
benefits of international investing are most apparent
after financial crises subside, given the heterogeneous
economic structures, capital-flow sensitivities,
commodity-price exposures, and varied monetary
and fiscal policy responses of countries around
the world.
References
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Forbes, Kristin J., and Menzie D. Chinn, 2003.
A Decomposition of Global Linkages in Financial
Markets over Time. Cambridge, Mass.: NBER
Working Paper No. 9555.
Kose, M. Ayhan, Christopher Otrok, and Eswar S.
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or Decoupling? IMF working paper 8/143.
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Chapter 4.
Vanguard Investment Counseling & Research > 13
Appendix
We collected annual data on real per-capita GDP
growth over the sample period 1951–2007 for the
49 countries currently in the MSCI World Equity
Index. We calculated real GDP growth rates for
developed markets, emerging markets, and various
regions based on real GDP weights. Figure 14
provides a complete list of the countries and
regional classifications and the first year for which
data were available for each country.
Figure 14. Regional classifications and data availability for international real GDP data
Developed
North America
Europe
Pacific
Emerging
United States
1951
Canada
1951
Latin America
Argentina
1951
Brazil*
1951
Chile
1952
Austria
1951
Columbia
1951
Belgium
1951
Mexico
1951
Denmark
1951
Peru
1951
Finland
1951
France
1951
Germany**
1971
Asia
China*
1953
India*
1951
Greece
1952
Indonesia
1961
Ireland
1951
Malaysia
1956
Italy
1951
Philippines
1951
Netherlands
1951
Thailand
1951
Portugal
1951
Pakistan
1951
Spain
1951
Sweden
1951
Egypt
1951
United Kingdom
1951
Morocco
1951
Norway
1951
Nigeria
1951
Switzerland
1951
South Africa
1951
Japan
1951
Czech Republic
1980
Australia
1951
Russia*
1991
New Zealand
1951
Hungary
1971
Hong Kong
1961
Poland
1971
Singapore
1961
Turkey
1951
Korea
1971
Jordan
1955
Taiwan
1952
Israel
1951
Africa
Eastern Europe
& Middle East
*BRIC country.
**Unified Germany. Before 1990 East and West Germany GDP data are combined. Data availability for East Germany limited to 1970 through 1990.
Sources: International Monetary Fund World Economic Outlook database, World Bank World Development Indicators, Penn World Tables, Thomson Datastream,
U.S. Census Bureau, and Vanguard Economic Strategy Group.
14 > Vanguard Investment Counseling & Research
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Contributing authors
John Ameriks, Ph.D./Principal
Joseph H. Davis, Ph.D./Principal
Francis M. Kinniry Jr., CFA/Principal
Roger Aliaga-Díaz, Ph.D.
Donald G. Bennyhoff, CFA
Geetesh Bhardwaj, Ph.D.
Maria A. Bruno, CFP ®
C. William Cole
Scott J. Donaldson, CFA, CFP ®
Michael Hess
Julian Jackson
Colleen M. Jaconetti, CPA, CFP ®
Karin Peterson LaBarge, Ph.D., CFP ®
Christopher B. Philips, CFA
Liqian Ren, Ph.D.
Kimberly A. Stockton
David J. Walker, CFA
Yan Zilbering
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