Chain Reactions

As the saying used to go, when U.S. markets sneeze, the rest of the world gets pneumonia. With capital zinging around the world at the speed of light, is that still true?

Markets worldwide shuddered in early March when Alan Greenspan uttered the word “recession” one too many times, sending the stock market in China down 9 percent, and others around the world with it, including in the U.S. Who makes who sick these days?

Jeff Erickson heads the team responsible for the $550 million in international investments managed by Lowry Hill, the Minneapolis-based wealth management unit of Wells Fargo. Based in Lowry Hill’s Naples, Florida, office, Erickson has been managing portfolios and analyzing investments for the past 20 years at firms in the U.S. and Switzerland. Prior to joining Lowry Hill, he was a portfolio manager for Advantus Capital in St. Paul, where he managed $1.5 billion in mutual funds and for institutional clients. Before that, he was the North American equity strategist for Credit Suisse in Geneva, Switzerland. He began his career as an analyst responsible for recommending stocks, fixed income private placements, and oil and gas limited partnerships and as a bank examiner for the U.S. Treasury Department’s Comptroller of the Currency.

{Q} We’ve all been taught that investing in international markets can help wring some of the volatility out of a domestic-only portfolio. Is that still true?

{A} Yes, I think it is. The correlation between foreign and domestic markets varies dramatically from year to year between countries and regions. So I think it’s important to look at the longer-term trends. If you look back 30 years, the correlation was about 0.3 to 0.4, which means that 30 percent to 40 percent of the movements in the markets between countries [was because they] were correlated to each other. If it was 1.0, or 100 percent, that would mean that they move in lockstep, and if it were a negative 1.0, that would mean that they move in exactly the opposite directions.

{Q} Has that number changed?

{A} Through 2006, it was about 0.5, so it has moved up. There’s been a general trend up in the correlation, but over that period of time, it has varied from a correlation of about 15 percent to a peak of about 70 percent. But the trend line over the long period has been slowly moving up.

{Q} A lot of research over the years suggests that the diversifying effect of foreign markets goes away when investors need the diversification the most.

{A} I think that’s still true. In a time of a crisis, the money is going to move to safety—to financial instruments such as U.S. Treasuries. You see that in Swiss government bonds as well. I don’t see that changing.

{Q} Historically, one of the attractions of international investing is the idea of investing in markets where companies might not be valued as efficiently. Has the pricing in these markets changed?

{A} Yes. I think you have to search harder to find attractive companies. But the higher flows of capital both into and out of a country can distort markets and create inefficiencies. For example, we think valuations in China and India have become excessive. So in one sense, you have to look at the broader picture—the valuations between countries. On the other hand, when you’re looking at the values of individual companies, you have to do your work to find attractive valuations.

{Q} We always used to say the U.S. stock market drove the rest of the world. Is that still true?

{A} While the correlation among markets is trending up, over the past roughly 15 years the world has added almost 4 billion people to the global market economy—people in countries that previously were closed to outside investors or to free-market mechanisms: China, India, the Soviet Union, Eastern Europe. So the U.S.’s share of the global market GDP is smaller than it used to be. China is a big enough economy that they’ve become a “second engine” in world GDP growth. So the role of the United States has become smaller, and I think that trend will continue. That’s a positive for correlations. When you’re the biggest player and your market sniffles, the rest of the world will get pneumonia. But when you’re a smaller player, you’ll have less of an impact on the rest of the world.