First DaimlerChrysler. Then the euro. For global investors, these events point to an important trend: Single-country indexing and single-country investing are becoming less relevant all the time.
The empirical literature by market researchers and academicians attributes the overwhelming majority of the dispersion of historical international investing results to the "country" effect. In other words, a money manager's choice of the "right" country in allocating his or her investible funds was, until recently, the single most important variable in explaining investment results. This phenomenon was especially important in emerging market economies where political and macroeconomic factors are important determinants of the investment climate.
However, worldwide inflation has moved secularly lower in recent years, as both monetary and fiscal policies in developed and emerging market economies have focused on greater price stability as the central policy objective. This focus on price stability, especially by central banks, has reduced country-by-country differences in expected and actual rates of inflation, as well as in nominal interest rates. This dampening has been, in turn, an important contributor to reduced volatility in major foreign exchange markets.
In addition, a number of regions around the globe have formed or are forming trade or currency blocs to help promote more stable conditions. Their underlying rationale is they can lead to an expansion in international trade and gains in asset prices. NAFTA, ASEAN, MERCOSUR and EMU -- the North American Free Trade Agreement, the Association of South East Asian Nations, the Common Market of the South in South America, and the European Monetary Union -- are notable examples of trade or currency blocs.
One consequence of these trade blocs and currency unions has been reduced country-by-country variability in stock prices. As worldwide stock prices tend to rise or fall in unison, the differences between country-by-country stock market results are lessening.
Contributing to this increasingly positive covariance of stock markets has been the on-going "globalization" of the business environment. In the United States, for example, more than 40% of the revenues of the biggest capitalization companies are now from non-U.S. activities.
The convergence of the world's financial markets is more obvious in fixed income than equity prices, as the interaction of inflationary expectations, real yields and nominal interest rates have resulted in yield curves that are much more in alignment today than just a few years ago. The statistical evidence of convergence is harder to discern in worldwide equity markets.
What are the implications for asset managers? The overall convergence of worldwide economic environments eventually will result in both fixed-income and equity prices rising and falling more in harmony. While it is probably still too early to designate a meaningful single worldwide measure of stock prices for global market participants, such measures are available and receiving serious scrutiny by institutional investors.
Does this mean country indexes are suddenly obsolete? No, they are valuable benchmarks, vehicles for passive investing and a convenient way to allocate, depending on the asset manager's macroeconomic viewpoint..
But, will the country "factor" continue to explain the overwhelming majority of the dispersion of returns around the globe? Probably not. Instead, sector or industry differences, as well as regional factors, probably will become increasingly important factors for explaining worldwide changes in equity prices.
Norman E. Mains is executive director of Dow Jones Indexes, South Brunswick, N.J.
