International Stock Markets Linkages: A Dynamic Factor Model Approach

This chapter investigates international stock market dynamics and their linkages. It uses factor models to extract stock market indicators from common cyclical stock components of industrialized countries, emerging markets, the BRICT, and global stock markets. We find that the stock market indicators for these groups are correlated with each other and with the global market factor. The BRICT display the highest average stock return and are the least correlated with the others. The stock return indicators as well as the global stock market factor show close relationship with economic downturns, entering in bear phases around the beginning of recessions, and in bull phases mid-way through recessions, anticipating future economic recovery. We also find that the stock return indicators are more persistent and, therefore, more predictable than the stock market of individual countries. We study international linkages across these stock market groups through impulse response analysis and find that economic development levels play and important role in shock propagation. In particular, all stock market indicators respond positively to global factor shocks, with the least reactive group being the BRICT, and the most responsive being the emerging markets. Interestingly, the BRICT respond negatively to positive shocks to industrialized countries stock markets, indicating that the BRICT may have a role in hedging risk.