Swings and roundabouts

Although currency traders are aware of the perils ahead, securities dealers have yet to wake up to them, perhaps because it is trickier to gauge how far world stockmarkets arc becoming more correlated. At some times they have seemed closely synchro­nised - as in October 1987 when most went into a tailspin. But at others they refuse to fly in formation: last year, the French stockmarket found it hard to get airborne, even as New York and London soared.

Many equity strategists believe that na­tional stockmarkets will move closer together. As an example, they point to the ex­perience of the European Union (EU). In a forthcoming study, a group of economists at BARRA International, a consultancy, looked at the correlation among 19 rich-country stockmarkets. After eliminating the effects of swings in the global economy and in individual industries, they found that nine eu stockmarkets have become more correlated since the early 1980s.

When they applied similar analysis to world stockmarkets, they found less evi­dence of increasing correlation. Yet many believe that world markets will undergo the same experience. One reason is that na­tional economies are be­coming more integrated. The main causes of this are increases in international capital flows and falling trade barriers. These factors will make national econo­mies - and hence stock-markets - more dependent on supply and demand in other economies.

A stronger argument still may be that direct barriers to integration are continuing to fall, as capital controls are rolled back and better tech­nology slashes transaction costs. As this happens, argues Robert Merton, a financial economist at Harvard Busi­ness School, national markets may be more exposed to world economic trends. This should make equity markets more closely correlated, threatening the profits of those who depend on diversity.

If you ask most equity analysts - even those who believe that more correlated markets lie just over the horizon - what all this might mean for trading profits, you are more than likely to be greeted with an ear­ful of fluff. One analyst who has given it se­rious thought, however, is Mark Cliffe, an economist at HSBC Markets, a British securities firm. He argues that increasing inte­gration will diminish the gains from diversification among rich-country markets dramatically. As a result, he claims, more fund managers will imitate the strategy of some American funds by “leapfrogging” part of the in­ternational diversification process: they will ignore many developed markets al­together, and invest in a combination of domestic and emerging-market equities since these are likely to remain less correlated for longer. This could cut the profits of mid-sized securities firms in America and Europe, which depend on the eager­ness of rich-country investors to pile into each other’s markets.

Nor will securities firms in emerging markets automatically benefit. For a start, if rich-country investors come rushing in, it will probably be because barriers, both eco­nomic and regulatory, fall. But it is these barriers that have given local firms an ad­vantage in the first place. Integrated global markets would also put local players at a disadvantage for another reason: the kind of information that is valuable would change dramatically, becoming more inter­national and less local. 

The big squeeze

Ultimately, even big firms in rich countries may be at risk. This is because the thing that they are promoting, and that is tying stock-markets closer together - bigger flows of portfolio capital - is going to pose a more direct threat to their livelihood. So will computer technology and increased aware­ness of costs among borrowers.

The main force behind increased port­folio flows is the expanding global reach of fund managers, who are slashing execution costs in several ways, none of them good for traders. Technology and deregulation are uncovering restrictive practices that have protected traders for years. And users of capital are questioning why they should pay bankers and brokers at all, rather than dealing direct with the fund managers. All this means that financial intermediaries are going to be under increasing pressure, from all sides. Some may relish the notion that increased integration means a smoother ride; but they may soon start to yearn for the old rollercoaster.

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