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.
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