UBS: Merging markets

Despite a slowdown in trade globalisation, it looks like equity markets are more globalised than ever. When one market falls, the contagion quickly spreads to bring the others down as well. This is a change from the past. In the old way of thinking about the world, the US sneezed and the world caught a cold.The S&P 500 was always viewed as the leading indicator for global equity markets. But the perception since last summer is that it is the Chinese equity market that is doing the sneezing.

Figuring out whether a drop in one equity market causes a drop in another is a tricky task. Just because the fall of one equity market is followed by a fall in another, does not necessarily mean that the first caused the fall in the second. To assume so would make you guilty of the logical fallacy of post hoc ergo propter hoc, or "after therefore because of". There could always be a third factor that is driving both equity markets down, but it so happens that the effect has fed through to one market earlier than the other. But given we can never test everything, there will always be the possibility of a third factor that we did not include.

That is why proper science (as opposed to the dismal science of economics) is based on the idea that you can never prove anything, only disprove something. And here at least economics, or more precisely, econometrics, can help us out. We can figure out if one equity market is good at predicting changes in another equity market. This is known as predictive causality (using a test named after the late Nobel-prize winning economist Clive Granger). If changes in one market are useless at predicting the change in another market, we have at least disproven the causality. If it is useful, then we have failed to disprove the causality (even if we cannot ever prove it).

Things get a bit more confusing when we realise that the causality can actually run in both directions. So a drop in the Chinese equity market might be predictively causing a drop in the US equity market, yet at the same time there is a feedback loop whereby US equities are predicting subsequent moves in the Chinese equity market. As so often in economics, it is hard to figure out whether the chicken or the egg came first.

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