28/11/2008: Decouple is not just the people next door

In 2007, when the US subprime hemorrhage began, it looked like a case for local anesthesia. The market chattered about how the world would simply “decouple” from the ailing American economy and there was a massive investment migration as money exited the US market. Indeed, we saw a veritable feeding frenzy for emerging market assets among investors from developed countries.

But today it is clear that when the US economy shivers, the rest of the world still feels a chill. At the moment, nearly every country is in or near recession, and those who aren’t members of this growing club still feel rundown by the slowdown.

Markets corrected worldwide in 2008 with the tight choreography of synchronized swimmers diving for the bottom. So, we ask, what happened to decoupling? Is over? Did it ever really happen, or was it just a buzzword in the wind?

The word decoupling usually has two applications. It relates to economies, their growth and their business cycles. And it also refers to markets and their correlation, or lack of same.

Surely, during all of 2007 and even the first quarter of 2008, decoupling was more than just a buzzword. It actually seemed to be happening. Remember, the US had already slowed considerably early in 2008, with only 0.9% annualized growth in the first quarter. At the same time, China registered another double-digit growth quarter, and other large emerging markets were also setting new growth records.

And back then, decoupling was not only an emerging market story. Germany also posted a whopping 5.2% annualized growth rate for the first quarter of 2008, and even Japan managed a strong 2.8%.

But as 2008 progressed, the local bleeding in the US spread globally, infecting the many countries exposed to the toxic US financial sector. Europe was especially hard hit. In early September, it became painfully clear that the US credit crunch would rock Europe just as hard as it was pounding the States. And with the US and Europe stumbling together into a deep recession, neither the emerging markets nor the commodity-exporting countries could not escape the global contagion.

So, for the first time since the early 1980s, we are experiencing a truly global recession, which could suggest that decoupling never took place. But in economics, as we often remark, correlation does not necessarily mean causality. Appearances can and do deceive.

We would argue that it was not the US recession that is leading the rest of the global economy to contract. What we are seeing instead are the consequences of a massive credit shock hitting both the US and the rest of the world at more or less the same time. Therefore, despite the business cycle being reset and synchronized globally, we think announcing the death of decoupling may be premature.

In terms of markets, the rest of the world hardly decoupled from the US in recent years. And this year, Wall Street still set the economic rhythm for stock markets worldwide early on. But as the financial crisis peaked, in late September and early October, we also saw Asian and European markets actually take the lead from Wall Street. So, while we again see a strong correlation between the US market and the markets of the rest of the world, causality is no longer quite as direct and rigid as it was only a couple of years ago.

We think investors would be mistaken to interpret today’s recoupled markets as a signal to avoid international diversification. We see this recoupling as a response to a once-in-a-lifetime global credit crisis. Despite the renewed correlation among international markets, we are convinced that an exposure abroad makes eminent good sense for many individual investors.

This is especially true for investors living in economies that rely on one or two specialized domestic sectors, or where the economy is highly commodity-dependent. Geographic diversification decreases their vulnerability to sharp movements in local markets and in its assets.

In a portfolio context, investing abroad is a good way to decrease volatility for the same expected return; or, alternatively, to increases the expected return for the same volatility. Decouple, we say, next door or even further afield. It’s good for you.

14/11/2008: The cheerless shine of gold

This should have been the perfect storm for gold. Between October 6th and October 10th, 2008 equity markets worldwide were falling at least by 15%. We were entering a weekend where the G7 and G20 would meet to discuss, how to find a solution to the unwinding financial crisis. There was no certainty at all that there would be a solution. Financial intermediaries on both side of the Atlantic were getting under major stress and the broad public was questioning the overall stability and viability of the financial system going forward. One obvious rational reaction in such a stressful environment should have been to buy the safe haven par excellence: gold.

But on October 10th, the same day where people were queuing in front of gold and coin retailers in London to buy bullion, gold fell from 913 to 850 US dollar an ounce. There are other paradoxes happening on the gold market. On October 27th, the news agency Dow Jones reported that a 24 karat pure one ounce bar of gold had attracted 12 bids, the highest being at 835 US dollar. Meanwhile, an ounce gold was selling at 729 US dollar on the spot market. How come that on the one hand there seems to be quite obviously a huge demand for physical gold, while on the other hand at the same time the gold price is falling?

One explanation might be that while they are obviously a large demand of gold, there might be an even larger supply of it. But why would anyone sell gold in such troubled times? Gold is liquid, i.e. quite easy to sell, but it is of course not a complete equivalent to cash. During a financial crisis, like the one we just experienced, cash is of course short everywhere, when it comes to fulfill some counterparty obligations or margin calls, therefore a large number of market participants need to get rid of their assets and this includes gold. So despite being considered as a “safe” asset, the volatility of gold within the last two months was roughly amounting to two third of the extremely volatile US stock market.

Does this speak against an investment in gold? Not necessarily. Despite its current high volatility, gold might nevertheless give you a good protection of value during those troubled times. Moreover, given the huge debt and money creation of the governments around the globe to mitigate the unfolding global recession, inflation expectations might significantly increase in the longer run. This also pleads in favor of gold. This said gold investors have to be disciplined. Gold has a tendency to create an emotional bonding with the investor, who would say: “it is the safest part of my portfolio; therefore I will never sell it”. This attitude could lead to big underperformances. After having traded above 600 US dollar an ounce in 1980 it took gold twenty six years to reach this level again. Hence a prudent investor buying gold must have a clear price target and also a stop loss and not be apprehensive to sell gold should it break through the stop loss.