Above the noise: US and European equities have not decoupled

Imperfect beta points to decoupling between US and European equities

If you watch the Bloomberg video The Math Behind the Decoupling, you get the idea US and European equities have been decoupled since 2010, and particularly so in 2012. This conclusion is based on an imperfect measure, beta, a still widely used legacy from the CAPM model. The beta can be very different depending on which of the two time-series you calculate the variance on and use in the denominator.

In the video clip it is shown how the beta on daily returns have declined in 2012. If I calculate the beta based on the Stoxx 600 Index instead of the MSCI Europe Index (used in the video clip) the beta is 0.59 in 2012, down from 0.78 in 2011 - compared to 0.45 and 0.63 respectively in Bloomberg video. Now this is based on Stoxx 600 variance in the denominator. If we use S&P 500 variance instead beta actually increased to 0.91 in 2012 up from 0.71 in 2011. This shows the instability of beta but also why it is not a good measure for co-movements.

Correlation shows huge increase in co-movements between US and European equities

If we instead use correlation on daily return observations then the correlation between S&P 500 and Stoxx 600 was 0.68, 0.74 and 0.73 in 2010, 2011 and 2012 respectively. Basically there is no significant change in the correlation between US and European equities.

We all know that daily return data have more noise so if you use monthly data instead you filter most of the noise. The chart below shows the 60-month rolling correlation between US and European equities and the cumulative (indexed) return since the beginning of 1995.

The conclusion is pretty clear. The correlation between US and European equities has increased from around 0.5 to 0.9 since 1995 as global capital markets have become more integrated and multinational companies have expanded into the same geographical regions. In essence the increase in free trade has made developed market equities more synchronised than ever. So we see no statistical evidence of decoupling despite the obvious difference in performance since early 2011.

Diversification should be based on a multi-asset approach

Since correlation between US and European equities are around 0.9 the diversification benefits from combining both equity markets into your portfolio is very limited. Proper diversification comes from combining returns streams that have low correlation, in particularly in different economic regimes, and as such investors should choose between either US or European equities when choosing their equity exposure. As you will see in our Quarterly Outlook, soon to be released, we are very cautious on European equities (except UK and German equities) and like US equities more.

Going back to the diversification issue. What investors should do is to create portfolios that contain equities, commodities, government bonds, corporate bonds and real estate. Most of these exposures can be obtained through liquid US-based ETFs. This will in return give you a high USD exposure which you should then diversify by holding other currencies such as EUR, CAD, AUD, JPY etc.