Asia Pacific Market Report AP Equities in Correlated World June 2012

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Asia Pacific Market ReporAsia Pacific Equities in a Correlated Worl

June 201

Asia Pacific Market Report

Asia Pacific Equities in a Correlated World

Zhijian Lou, Neil Gilfedder and Zoltan Nagy

[email protected]

[email protected]

[email protected]

June 2012

IntroductionThe 2008 financial crisis put global markets into a volatile risk-on / risk-off swing, where investors have

been driven by two opposing views of the future. When people worry about recession or deflation, their

risk aversion goes up and they shift to low-risk assets, thus hurting risky assets like equities. In contrast,

when people expect a recovery or inflation, their risk aversion goes down and they shift into high-risk

assets.

This binary attitude results in a high degree of synchronization among the movements of different

markets, thus causing a high degree of correlation. High levels of correlation may point to a common

source of risk across all markets. Under these conditions, the higher the market correlation, the higher

the portfolio volatility.

This risk-on / risk-off climate has been with us for five years and investors are looking for ways to handle

the correlated swings in global markets. In this paper, we examine these high correlations and see if

they affect the Asia Pacific markets (ex-Japan). Barra regional models are used to gauge correlations

among Asia, the U.S. and Europe, focusing on how Asia Pacific equities may be contaminated by global

risk-on / risk-off swings.

Rising Correlations

While the economies in Asia Pacific have kept growing, there has been slow growth in the U.S. andausterity in Europe. Given its growth status, can we expect the Asia Pacific market to be exempt from

the risk-on / risk-off asset allocation?


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In Figure 1 through Figure 3, correlations of market returns have been compared between the pre-crisis

and post-crisis periods. The cross-market rolling correlation tracks the strength of the common price

component.1

Notice that the cross-market rolling correlations were pushed high and have remained high since the

2008 financial crisis. The pre-crisis correlation between Asia and U.S. fluctuated around zero, while the

post-crisis correlation leaped into positive territory and remained there. Similarly, the rolling correlationbetween U.S. and Europe has steadily risen and has almost doubled after the crisis. Today it is up to an

all-time high of 86 percent. In contrast, the relationship between Asia Pacific and Europe resembled an

expanding sine wave, suggesting more volatility in the correlation.

Figure 1: Correlations of Market Returns: Asia Pacific and the U.S., Pre-Crisis versus Post-Crisis.

1The region/country factors of three Barra equity models are used to calculate daily returns of three regional markets. Daily returns of Asia Pacific markets are

estimated with the Barra Asia Pacific Equity Model ex Japan (ASE1SXJP) and MSCI All Country (AC) Asia Pacific ex Japan Index. Daily returns of the U.S. market are

estimated with Barra U.S. Equity Model (USE4S) and the MSCI USA Index. Daily returns of Europe markets are estimated with the Barra Europe Equity Model

(EUE3S) and the MSCI Europe Index. All the three regional returns are denominated in USD.

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003-01-02 2005-10-20 2008-08-07 2011-05-26

RollingCorrelation

Asia Pacific market and U.S. market


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Figure 2: Correlations of Market Returns: Asia Pacific and Europe, Pre-Crisis versus Post-Crisis.

Figure 3: Correlations of Market Returns: the U.S. and Europe, Pre-Crisis versus Post-Crisis.

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003-01-02 2005-10-20 2008-08-07 2011-05-26

RollingCorrelation

Asia Pacific market and Europe market

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2003-01-02 2005-10-20 2008-08-07 2011-05-26

RollingCorrelation

U.S. market and Europe market


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These higher levels of the post-crisis correlation suggest that the returns from Asia Pacific markets have

become increasingly similar with the U.S. and Europe.

Relative to market returns, macro volatility appears to be a more significant driver of stock correlations.

Figure 4 through Figure 7 compares the correlation of market volatilities between the pre-crisis and

post-crisis periods.2

Figure 4: Correlations of Market Volatilities: Asia Pacific and the U.S., Pre-Crisis.

2Daily volatilities of region/country factors are calculated across three regional markets. Daily volatilities of Asia Pacific market are estimated with Barra Asia Pacific

Equity Model ex Japan (ASE1SXJP) and MSCI AC Asia Pacific ex Japan Index. Daily volatilities of U.S. market are estimated with Barra U.S. Equity Model (USE4S) and

MSCI USA Index. Daily volatilities of Europe market are estimated with Barra Europe Equity Model (EUE3S) and MSCI Europe Index. All the three regional volatilities

are denominated in USD.

Asia = 0.94*US - 0.01

R = 41%

10%

20%

30%

40%

50%

10% 15% 20% 25%

AsiaPacific

U.S.

Pre-crisis: Asia vs US (2003-2006)


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Figure 5: Correlations of Market Volatilities: Asia Pacific and the U.S., Post-Crisis.

In the volatility landscape, the Asia Pacific market has become far more correlated with the U.S. and

Europe after the financial crisis. Correlations before the crisis were not impressive, with R-squares at 40

percent. After the crisis, however, the correlations increased, with R-squares rising to 80 percent. The

results suggest that disparate equity markets have a much greater tendency to move together than

before, and individual stocks are increasingly dominated by a common price component.

Figure 6: Correlations of Market Volatilities: Asia Pacific and Europe, Pre-Crisis.

Asia = 1.27*US - 0.08

R = 82%

10%

20%

30%

40%

50%

10% 20% 30% 40% 50% 60%

AsiaPacific

U.S.

Post-crisis: Asia vs US (2007-2012)

Asia = 1.71*EU - 0.10

R = 48%

10%

20%

30%

40%

50%

10% 15% 20% 25%

AsiaPacific

Europe

Pre-crisis: Asia vs Europe (2003-2006)


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Figure 7: Correlations of Market Volatilities: Asia Pacific and Europe, Post-Crisis.

As shown in Figure 5, the U.S. market volatilities are not only mirrored in the Asia Pacific region, but

even amplified by a factor of 1.27 in the post-crisis period. Similar to a high-beta stock, a more volatile

market is likely to underperform in a down-market. In fact, the MSCI Asia Index did underperform the

MSCI USA Index during the last five years. As the one growing economy in the world, the Asia Pacific

region ends up much choppier than other regions trapped in recession. Why?

Asia has long been a fast-growing territory; paradoxically, that happens to be the source of its weakness,

since the flip side of Asias strength is its dependency on the demand of other markets. A severe

balance-sheet recession dries up global demand, which exposes Asias weakness. That explains how Asia

Pacific exposures might become another risk-on manifestation despite its growth status.

Country Diversification in AsiaAny stock has an exposure to macro risk and some stock specific alpha. An increase of cross-market

correlation could deplete Asia-specific sources of returns. With all the markets behaving a similar way,

many wonder: is there any Asia-specific return remaining? In fact, these returns are still available, and

we can trace them through two distinct channels.

First, to what extent is Asia dominated by the global common price component? Asias return

correlation with other regions remains weak in comparison to other markets; the recent April 2012

figure highlights the point. As shown in Figure 1, Asia has a weak, albeit positive, relationship to the U.S.

with a correlation in the low teens. By contrast, the correlation between the U.S. and Europe remains at

an all time high of 85-86 percent.

Asia = 0.88*EU + 0.01

R = 81%10%

20%

30%

40%

50%

10% 20% 30% 40% 50%

AsiaPacific

Europe

Post-crisis: Asia vs Europe (2007-2012)


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Second, to what extent is Asia internally correlated? By comparing the country effect between Asia

versus Europe markets,3 we found that the benefit of country diversification is rich in Asia, but negligible

in Europe. Figures 8 10 are illustrative.4

Figure 8: Country Risk: Asia Pacific and Europe.

The first chart (Figure 8) shows that the Asia Pacific region has had much higher volatility of country

factors than its regional counterpart in Europe. Higher country risk tends to have a larger size of country

factor returns, indicating that a proper country allocation in the Asia Pacific market could be a built-in

mechanism of risk reduction and return enhancement.

3The Barra Asia Pacific Equity Model ex Japan covers 14 countries (ASE1xJP) and the Barra Europe Equity Model include 29 countries (EUE3).

4 Asia Pacific country volatilities, country risk contributions and correlations are estimated with Barra Asia Pacific Equity Model ex Japan (ASE1SJP) and the MSCI ACAsia Pacific ex Japan Index. Europe country volatilities, country risk contributions and correlations are estimated with Barra Europe Equity Model (EUE3S) and the

MSCI Europe Index.

0%

1%

2%

3%

4%

5%

2002 2004 2005 2006 2008 2009 2010 2012

Cou

ntryRisk

Asia Pacific

Europe


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Figure 9: Risk Contribution of Country Factors, Asia Pacific versus Europe.

In the second chart (Figure 9), we see a negative risk contribution of country factors. The negative value

of risk contribution confirms that diversification might benefit Asia Pacific investors through diverse

country allocations. By contrast, such a diversification effect was negligible for Europe markets.

-3.2%

-2.4%

-1.6%

-0.8%

0.0%

2002 2004 2005 2006 2008 2009 2010 2012

CountryRiskCountribution

Asia Pacific

Europe


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Figure 10: Correlation of Country Factors to the Underlying Market, Asia Pacific versus Europe.

Lastly, the third chart (Figure 10) tracks the source of diversification. The country-factor returns have a

strong and negative relationship with the underlying market. In the Asia Pacific, such a negative

correlation has remained steady over time in a range of 40 to 60 percent with only a brief dip into

the high teens during the 2005 credit stress and the 2003 deflation fear. Even in late 2008 and early

2009, hammered by extreme market moves, the negative correlations stayed as high as 60 percent and

the diversification benefits reached an historical high.

The negative correlation, however, collapsed to an all-time low of 10 percent since the second half of

2011, and so did diversification benefits. There could be two potential explanations. It could be a

temporary dip, as it happened before, due to a massive repatriation of money back to Europe as a result

of the eurozone banking crisis last year. It might also represent an early signal of major structural shift in

the Asia Pacific region as the Chinese economy slows down.

-80%

-60%

-40%

-20%

0%

20%

2002 2004 2005 2006 2008 2009 2010 2012

Correlation

Asia Pacific

Europe


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June 201

ConclusionAsset management has become more challenging with disparate markets moving in lockstep and

swinging between risk-on and risk-off phases. An elevated cross-market correlation has even spilled

over into an unlikely place the Asia Pacific market.

Through the lens of the Barra regional models, we see that the Asia Pacific market tends to follow, and

even amplify, U.S. market volatilities. However, this correlation does not diminish the market identity of

the Asia Pacific region. In our study, the Barra models helped to uncover diversification benefits

embedded in the country factors. Our analysis suggested that searching for Asia Pacific alpha has

become more urgent, and challenging, as macroeconomics movements matter more and more in this

correlated world.


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June 201

Appendix: Monthly Asia Pacific Market Equity Watch

Market Environment

Figure 11: Performance and Risk Forecast, MSCI AC Asia Pacific ex Japan IMI, December 1994 April 2012.

Figure 12: Performance and Risk Forecast, MSCI AC Asia Pacific ex Japan IMI, October 31, 2011 30 April 30,

2012.

10%

15%

20%

25%

30%

35%

0

50

100

150

200

250

All Country Asia ex Japan IMI Index Asia ex Japan Regional Factor Risk (right axis)

17.5%

18.0%

18.5%

19.0%

19.5%

20.0%

20.5%

21.0%

21.5%

22.0%

22.5%

80

85

90

95

100

105

110

115

120

All Country Asia ex Japan IMI Index Asia ex Japan Regional Factor Risk (right axis)


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Figure 13: Risk Forecast for the Regional Factor, Asia Pacific ex Japan Model Long and Short Versions,December 1994 April 2012.

Figure 14: Risk Forecast for the Regional Factor, Asia Pacific ex Japan Model Long and Short Versions, 31October 2011 30 April 2012.

5%

10%

15%

20%

25%

30%

35%

40%

45%

Asia ex Japan Regional Factor Risk (right axis) long model

Asia ex Japan Regional Factor Risk (right axis) short model

15%

16%

17%

18%

19%

20%

21%

22%

23%

24%

25%

Asia ex Japan Regional Factor Risk (right axis) long model

Asia ex Japan Regional Factor Risk (right axis) short model


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Figure 15: Risk Forecasts of the Five Most Risky Countries, ASE1XJP Model, December 1996 April 2012.

Figure 16: Risk Forecasts of the Five Most Risky Countries, ASE1XJP model, 31 October 2011 30 April2012.

0%

10%

20%

30%

40%

50%

60%

China Domestic Indonesia India Pakistan Thailand

10%

15%

20%

25%

30%

China Domestic Indonesia India Pakistan Thailand


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MSCI Applied Research msci.com


June 201

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Asia Pacific Market Report AP Equities in Correlated World June 2012

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