International Equity Market Comovements: Economic Fundamentals or Contagion?

Abstract

We investigate the causes of the contemporaneous return comovement in international equity markets with a focus on the distinction between economic fundamentals and contagion. We examine the potential news effect based on a comprehensive data set of the macroeconomic news announcements made in the U.S., U.K., and Japan from 1985 to 1996. We report three major findings. First, foreign intraday trading significantly influences domestic markets even after we control for the macroeconomic news impact. This result is robust for all models and across all three countries. This suggests that foreign trading does convey information distinct from the public information flows, measured by the macroeconomic news announcements. Second, foreign market trading impacts domestic overnight returns more profoundly than domestic intraday returns. In our setup, domestic overnight returns precede domestic intraday returns for the same calendar day. Hence the bigger impact on the domestic overnight returns implies that domestic markets efficiently process the information disseminated from foreign market trading on a timely basis. Third, we find that although foreign macroeconomic news announcements have little measurable impact before the Crash in October 1987, their influence on domestic markets tend to increase after the Crash and, in particular, during the 90's. Furthermore, there is evidence that the effect of foreign macroeconomic news announcements increases when the announcements are accompanied with large movement in foreign intraday returns or when the volatility of the announcements is large. The increasing importance of these macroeconomic news announcements does not mitigate the influence of foreign market trading. In fact, our result shows that in each country the two foreign intraday returns are far more important than the preceding domestic returns and all macroeconomic news announcements taken together in explaining the variations in the domestic intraday and overnight returns. In one sense, our results suggest the potential importance of a contagion effect. Our results show that the bulk of the observed comovement in the intraday and overnight returns of the international equity markets cannot be attributed to public information about economic fundamentals. As a result, future inquiry on this issue may focus on the distinction between contagion and private information, rather than public information. Alternatively, future research on this subject may need to consider stock return data finer than the intraday and overnight returns employed in this paper.