The Core, Periphery, and Beyond: Stock Market Comovements among EU and Non‐EU Countries

• Date: 01 February 2019
• Published date: 01 February 2019
• DOI: http://doi.org/10.1111/fire.12186

The Financial Review 54 (2019) 5–56

The Core, Periphery, and Beyond: Stock

Market Comovements among EU and

Non-EU Countries

Michael A. Goldstein

Babson College

Joseph McCarthy

Bryant University

Alexei G. Orlov∗

U.S. Securities and Exchange Commission

Abstract

Using linear and nonlinear correlations, copulas, quantile dependence and lower tail

dependence, we find that (1) equity markets of the advanced European Union (EU) countries

comove more closely with each other than with the peripheral economies, (2) comovements

with non-EU countries are lower, (3) relative comovement structure before, during, and after

the global financial crisis has been very stable, and (4) the level of comovements remained

virtually the same between the crisis and post-crisis periods. Our results are robust to controlling

∗Corresponding author: U.S. Securities and Exchange Commission, 100 F Street NE, Washington, DC

20549; Phone: 202-551-6434; E-mail: orlova@sec.gov.

We thank conference participants at the 2016 Financial Management Association and our discussant

Fernando Moreira, and two anonymous referees for immensely helpful comments. Wealso thank Andrew

Patton and James P. LeSage for sharing their MATLAB codes for computing quantile dependence. The

authors of this paper are responsible for any errors oromissions. The Securities and Exchange Commission,

as a matter of policy, disclaims responsibility for any private publication or statement by any of its

employees. The views expressed herein are those of the authors and do not necessarily reflect the views

of the Commission or the authors’ colleagues on the staff of the Commission.

C2019 The Eastern Finance Association 5

6M. A. Goldstein et al./The Financial Review 54 (2019) 5–56

for Fama-French, U.S. and global risk factors, as well as monetary policy,market interest rates,

exchange rates, and uncertainty.

Keywords: financial interdependence, comovements, European stock markets, PIIGS, Brexit,

copulas, global financial crisis

JEL Classifications: C14, F30, F37, G10, G15

1. Introduction

The vote in the United Kingdom (UK) on June 23, 2016, to leave the European

Union (EU) raised a variety of questions, including how and what EU membership

affects. Although the UK’s exit from the EU will affect a variety of trade and immi-

gration issues, the Brexit vote (see, e.g., The Economist, 2016) also raises interesting

questions about how Eurozone and EU membership affects comovements across not

just the labor and goods markets but financial markets as well. This is especially

pertinent since the UK is (still) a member of the EU but did not adopt the euro as

its currency, unlike many other EU members such as Germany and France. As eq-

uity markets tend to aggregate the effects of goods, labor, foreign exchange, interest

rates and capital markets, an important question is how EU membership (and non-

membership) affects equity market comovements among advanced and nonadvanced

economies. Compounding these issues was the adoption of the euro as a common

currency on January 1, 1999, which removed some diversification effects due to

currency movements across Eurozone countries. Even so, notable differences remain

across countries that use the euro.

In this paper, we examine the interrelationships among the core and periphery

EU and Eurozone countries, and those of the UK and beyond. We try to answer three

main research questions. First, how are comovements among European stock markets

affected by the EU affiliation versus adoption of the euro? Second, do the European

periphery economies’ stock markets comove more or less with each other than with

the stock markets of the core European countries? Third, how does the structure of

stock market comovements change between tranquil and crisis periods?

Overall, we find that the core EU and Eurozone countries comovemore with each

other than any other group, and that the periphery EU and Eurozone countries comove

more with the core than with each other. As the use of the euro and membership in the

EU is removed, the stock market comovements become reduced. Interestingly, using

a variety of statistical techniques, we find that the relative structure of comovements

across countries prior to the crisis remained relatively constant before, during, and

after the crisis. Notably,the absolute magnitude of the comovements increased during

the financial crisis but did not diminish after the crisis. These effects continued to

hold even after controlling for macroeconomic effects, Fama-French risk factors, or

market controls as in Bekaert, Ehrmann, Fratzscher and Mehl (2014).

M. A. Goldstein et al./The Financial Review 54 (2019) 5–56 7

This study contributes to two closely related strands of the literature—financial

markets comovements and financial contagion (e.g., King and Wadhwani, 1990;

Morck, Yeung and Yu, 2000; Kodres and Pritsker, 2002; Baele, 2005; Bekaert, Har-

vey and Ng, 2005; Bekaert, Hodrick and Zhang, 2009; Mendoza and Quadrini, 2010;

Christoffersen, Errunza, Jacobs and Langlois, 2012; Bekaert, Ehrmann, Fratzscher

and Mehl, 2014; Dungey and Gajurel, 2014; Caporin, Pelizzon, Ravazzolo and

Rigobon, 2018). Although Solnik (1974) suggests that international investing adds

substantial diversification benefits, more recent works by Chollete, de la Pe˜

na and

Lu (2011), Christoffersen, Errunza, Jacobs and Langlois (2012), Fern´

andez-Avil´

es,

Montero and Orlov (2012), and others note that comovements in financial markets

notably reduce the benefits of diversification. Aloui, A¨

ıssa and Nguyen (2011) state

that “correlations of global stock returns have increased in the recent periods as a

result of increasing financial integration, leading to lower diversification benefits

especially in the longer term” (p. 130), and note that “[a] number of past studies have

reported the existence of significant linkages both between emerging and developed

markets, and among emerging markets” (p. 131, emphases added). At the same time,

recent events tied to the global financial crisis have affected different economies to

differing degrees. These events have particularly affected highly indebted countries

such as Portugal, Ireland, Italy, Greece and Spain (PIIGS) that were at the center

of the Eurozone debt crisis, as compared with more developed economies such as

France, Germany and the UK or the non-EU countries of Switzerland, South Africa,

Japan and the United States.1

To examine these cross-country differences, we start with two core EU and

Eurozone economies—France and Germany—and expand the sample by building

concentric circles outward. We include five EU peripheral countries that adopted

the euro—PIIGS—then expand to the UK, which is part of the EU but does not

use the euro, and Switzerland, a European nation that is neither in the EU nor in

the Eurozone but share languages and is contiguous with both France and Germany.

We further expand our circle geographically to include (1) the United States, a G7

common-law country culturally similar to the UK, (2) South Africa, another common-

law country culturally similar to the UK but smaller and likewise geographically

distant, and (3) Japan, another large G7 country distant from the rest of the sample.

This set of countries differ by EU and euro adoption as well as geographically,

culturally, and by market size.2We then use multiple statistical methods—from

1All of the PIIGS economies share an important feature that separates them from countries such as France

or Germany—namely, high debt-to-gross domestic product (GDP) ratios, which manifested in domestic

macroeconomic problems and which became a concern for other European economies. The data that we

analyze support our categorization: stock market indices for Germany,France and the UK are at or above

the Eurozone index (described in detail in Section 3), whereas Italy,Spain and the other PIIGS economies

are distinctly below.

2Chui, Titman and Wei(2010) and many others examine the link between culture and international stock

market returns.