Where European Stocks Go, Asia Will Follow

Investors looking for clues as to where Asian equities are headed should look at European markets, which appear to be increasingly setting the tone for regional stocks.

Yoshikazu Tsuno | AFP | Getty Images

Asia’s stock markets, which have traditionally taken their cue from Wall Street, have in recent months moved in tandem with their European peers, according to Japanese brokerage Nomura.

They point out that the correlation coefficient - a measure that determines the degree to which the movement in two assets is associated - between Asian and European markets has risen to an eight-month high of 30 percent from a low in April of just 9 percent.

“This implies that Europe remains a key driver of global riskand opportunity,” Nomura’s equity market strategists said in a research note. “This elevated correlation works in Asian equities’ favor, of course, as European policymakers further progress toward a more effective policy framework.”

The European Central Bank (ECB), which meets on Thursday, is widely expected to outlineplans to buy the bonds of those euro zone members such as Spain that have faced pressure from high borrowing costs this year.

An expectation that Europe will take definitive steps to end the debt crisis in the euro zone has underpinned a rally in global markets. Between early June and late August, European shares rose about 17 percent, while Asian stock markets gained about 14 percent.

In the past week, where markets in Europe have ceded some ground and retreated about 4 percent, Asian markets have also pulled back at about the same pace.

“What has been a key driver of markets is monetary policyand stimuli in Europe and the U.S. in the last year. A common driver means a more synchronized performance of markets and, thus, higher correlations,” said Herald Van Der Linde, Head of Equity Strategy Asia-Pacific at HSBC in Hong Kong, agreeing that the relationship between Asian and European markets has become stronger in recent months.

All About Europe

What the increased correlation between Asian and European shares means is that rather than being driven by the outlook for Asia’s economy, regional share markets will be influenced more by the flow of European news and its impact, good or bad, on European shares.

According to Nomura, the behavior of European shares in recent weeks suggests that markets are in a mood to react positively to signs of progress in solving the euro crisis.

Besides looking at steps the ECB may announce on Thursday, markets are also awaiting upcoming key events such as a German Constitutional Court ruling next week on the legality of the euro zone’s financial rescue fund, the European Stability Mechanism, and a euro zone finance ministers meeting on September 14-15.

However, there is a downside to the strong correlation between Asian and European shares, said HSBC’s Van Der Linde. “It (the tight correlation) means it is more difficult to diversify between markets,” he added.

By CNBC’s Dhara Ranasinghe