Selecting macroeconomic variables as explanatory factors of emerging stock market returns

Emerging stock markets have been identified as being at least partially segmented from global capital markets. As a consequence, it has been argued that local factors rather than global factors are the primary source of equity return variation in these markets. This paper seeks to address the question of whether local macroeconomic variables have explanatory power over stock returns in emerging markets. Moderate evidence is found to support this contention. Furthermore, using a principal components approach, two types of commonality in returns are examined. Evidence is found that supports commonality in the factors that drive return variation across emerging markets. A test is also conducted for identical sensitivity to a common set of extracted factors. While little evidence of common sensitivities is found when emerging markets are considered collectively, considerable commonality is found at the regional level. These results have implications for international investors as they suggest that the benefits from diversification are enhanced when the allocation of funds is spread across, rather than within, regions.