Co-movements in financial fluctuations are anchored to economic fundamentals: A mesoscopic mapping

TL;DR

This paper uncovers a robust empirical link between financial sector networks and economic fundamentals, showing that sector size influences return dynamics across multiple countries and market conditions.

Contribution

It introduces a mesoscopic mapping approach connecting nominal financial networks with economic fundamentals, highlighting the role of sector size in network core-periphery structure.

Findings

Large sectors form the core of return networks

Sector size metrics correlate with network centrality

Results are consistent across different countries and market periods

Abstract

We demonstrate the existence of an empirical linkage between the nominal financial networks and the underlying economic fundamentals across countries. We construct the nominal return correlation networks from daily data to encapsulate sector-level dynamics and figure the relative importance of the sectors in the nominal network through a measure of centrality and clustering algorithms. The eigenvector centrality robustly identifies the backbone of the minimum spanning tree defined on the return networks as well as the primary cluster in the multidimensional scaling map. We show that the sectors that are relatively large in size, defined with the metrics market capitalization, revenue and number of employees, constitute the core of the return networks, whereas the periphery is mostly populated by relatively smaller sectors. Therefore, sector-level nominal return dynamics is anchored to the real size effect, which ultimately shapes the optimal portfolios for risk management. Our results are reasonably robust across 27 countries of varying degrees of prosperity and across periods of market turbulence (2008-09) as well as relative calmness (2015-16).