Research shows that crises do more than cause financial market volatility and falling share prices – they lead to markets becoming far more interconnected.
Published in the Journal of Risk and Financial Management, the study by Dr Domenico Vicinanza of Anglia Ruskin University (ARU) in Cambridge, England, examined the behaviour of major stock markets on both sides of the Atlantic during the Global Financial Crisis and the start of the Covid-19 pandemic.
Using a statistical technique derived from chaos theory, known as convergent cross-mapping, the study analysed movements in the Dow Jones Industrial Average, S&P 500, FTSE 100 and DAX before, during and after each crisis.
Unlike conventional approaches that focus on correlation – market A directly causes a movement in market B – the study examined whether the dynamics of one market contained recoverable information about another, an indicator of deeper nonlinear connections between markets.
Studying nonlinear dynamical coupling, where markets become linked through factors such as feedback loops, investor sentiment and policy announcements, shows the extent to which the behaviour of one market leaves a detectable footprint in another. In practical terms, this means the behaviour of one market becomes increasingly informative about the behaviour of others.
The research found that market interconnectedness increased sharply during both crises studied, with markets responding more strongly to the same global pressures.
The most striking results emerged during the early months of the Covid-19 pandemic. Every market relationship tested between the Dow Jones, S&P 500, FTSE 100 and DAX suggested that the crisis produced a broad strengthening of links across the system, rather than reflecting temporary movements alone. The study’s average coupling measure increased by 16% from the pre-crisis period to the crisis period.
The research found that the strengthening of these connections happened quickly, with the strongest links between US and European markets appearing within a window of three trading days, and many happening simultaneously.
While Covid-19 produced a sharp but relatively short spike in connectivity during the crisis phase, the strong links between markets lasted for longer during the Global Financial Crisis, with coupling continuing and then peaking in the post-crisis phase.
The research also showed that these connections were not flowing in a single direction, although the US markets exerted a slightly stronger influence on European markets during the pandemic.
Author Dr Domenico Vicinanza, Associate Professor of Intelligent Systems and Data Science Anglia Ruskin University (ARU), said: “This study shows that methods derived from chaos theory can provide new insights into the behaviour of financial markets.
“Convergent cross-mapping complements established tools such as correlation analysis and volatility measures by revealing how markets interact as complex, evolving systems and it highlights that the connections between markets can be just as important as the behaviour of individual markets.
“If two markets are genuinely connected, the movement of one market may leave a detectable trace in the other. It is a bit like seeing footprints in the sand. You may not see the person walking, but the footprint tells you that something has passed through. In this case, the ‘footprint’ is a pattern in the data showing that one market carries information about another.
“Understanding connections is vital because financial risk is not determined only by how much one market falls by or how volatile it becomes. Financial risk depends on the closeness of connections between markets when stress spreads through the system. If markets become more dynamically coupled during crises, then diversification, hedging and risk monitoring may need to take account of this changing structure.
“During the Covid-19 crisis in particular, the major US and European markets behaved less like separate markets and more like parts of a single, tightly connected global system, which may explain why traditional strategies offered limited protection during the sharp market sell-off of early 2020.
“When markets become tightly linked, shocks can spread more rapidly, and investors have fewer opportunities to reduce risk through diversification. Rather than being driven by local factors, markets in times of crisis become influenced by common global forces, and the behaviour of one market becomes more informative about the behaviour of others.”
Journal of Risk and Financial Management
Nonlinear Market Coupling During COVID-19 and the Global Financial Crisis: A Convergent Cross-Mapping Analysis of US and European Equity Indices