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Explaining Decoupling in the Markets


Decoupling is simply the notion of a decrease in correlation.

Editor's Note: We received several inquiries requesting further discussion of the ideas mentioned in Minyan Satyajit Das' latest article, Investment Theme du Jour. Editorial staff member Andrew Jeffery offers further perspective.

The primary goal of Minyan Satyajit's piece on the Investment Theme du Jour is to explain the concept of decoupling, and the extent to which the separation of various previously connected investment classes is affecting the financial markets, and as a result the world economy. A Herculean task no doubt, and one that could fill many volumes.

Decoupling is simply the notion of a decrease in correlation. To set financial markets aside for a moment to grasp the concept, as children grow older and become more independent, you could argue they decouple from their parents and their actions take on their own voice, or that they listen to new and different influences. Essentially children become less and less connected to what used to be a driving force in the determination of their actions.

To return to the financial markets and Satyajit's article, he says that "equity markets have decoupled from debt markets, [and] emerging markets have decoupled from developed markets" in citing two primary examples of decoupling.

For a long time, debt downgrades, rising defaults, and a general deterioration in credit quality was a fairly reliable sign that economic trouble was on the horizon and corporate earnings were in trouble. Earnings tended to drive stock prices and as a result stock prices would come under pressure as problems in the debt market forced investors readjusted their expectations downward. The author suggests this dynamic may be changing.

He acknowledges that debt "is distinctly out of favor" but argues that certain structural aspects of the debt market such as a lack of transparency, poor liquidity and concern over the validity of credit ratings – that one could argue have nothing to do with equity markets and stock prices – have played a significant role in the degradation of various debt instruments. In addition, rising inflation in energy and food will erode the value of future cash flows paid to the holders of debt, while these forces could potentially be a boon for certain sectors of the stock market that benefit from higher prices.

Here we see an example of decoupling, where new dynamics in the fixed income market may not have the same effect on equity markets as in the recent past. Furthermore, new sources of investment capital such as sovereign wealth funds may provide demand, where 20 years ago there would have been only supply. We see this most clearly in the recent equity sales by Citigroup (C) and UBS (UBS).

Satyajit's second point is one of the most heated debates in global economic circles: the concept that emerging markets no longer need to rely on U.S. demand to drive economic growth.

Since the United States emerged as the dominant world economy after the Second World War, its demand for goods and services has driven much of the world's industrial development. The U.S. was simply the biggest market in the world, and since it had the biggest guns to boot, countries with visions of growth were dependent on the U.S.' demand to sustain their economic expansion.

Many would argue this has changed. China, India, Brazil, Central Europe and other regions of the world have emerged as sizable markets for goods and service. The decoupling argument is that even if the U.S. economy slips into recession and its demand for the world's products falls, these new economies can pick up the slack. Countries heretofore dependent on the United States to prop up their fledgling economies can turn to new markets to peddle their wares.

To be sure, Satyajit goes into more detail on each of these subjects, but his primary thesis is that the dynamics of the interplay between global financial markets and the world's economies could be undergoing a fundamental change, and the extent to which that premise is or is not true, in his opinion, is the "Investment Theme du Jour."
No positions in stocks mentioned.

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