What is decoupling?

Decoupling occurs when the returns of an asset class deviate from their expected or normal correlation model with the others. Decoupling takes place when different asset classes that generally increase and decrease together begin to move in opposite directions, one increasing and the other decreasing.

An example can be seen with the prices of oil and natural gas, which generally rise and fall together. Decoupling occurs when oil moves in one direction and natural gas moves in the opposite direction.

Key points to remember

  • Decoupling occurs when the returns of an asset class that have been correlated with other assets in the past no longer move in phase.
  • Decoupling can also refer to a disconnect between the performance of a country’s investment market and the state of its underlying economy.
  • Investors may view decoupling as an opportunity if they believe the previous correlation model will return, but there is no guarantee that it will.

Understanding decoupling

In the investment industry, investors and portfolio managers typically use a statistical measure called correlation to determine the relationship between two or more assets. The strength of the correlation between two assets depends on where the metric is in the range of -1 to +1, where a higher number indicates a stronger synchronization between the investments being compared.

A correlation of -1 implies that the assets move in the opposite direction, and +1 means that the assets will always move in the same direction. By understanding which assets are correlated, portfolio managers and investors create diversified portfolios by allocating uncorrelated investments among them. In this way, when an asset value falls, the other investments in the portfolio do not have to follow the same path.

Equities in the same industry will generally have a high positive correlation. For example, in 2020, when Goldman Sachs compared FAAMG stocks – Facebook, Apple, Amazon, Microsoft and Google (Alphabet) – to the tech bubble of the late 90s, there was a liquidation that led to a fall the share prices of most technology companies on the American market.

When a group of highly correlated investments or commodities deviates from their correlative attributes, a decoupling takes place. For example, if negative information about gold increases the value of certain mining companies (which would normally be negatively affected by news), these companies would be decoupled from gold prices. Indeed, decoupling refers to a decrease in the correlation.

Decoupling of markets

The markets and economies that once came together can also be decoupled. The 2008 financial crisis that erupted in the US economy eventually spread to most markets around the world, leading to a global recession. Since markets are “coupled” to economic growth in the United States, any market that departs from the global trajectory is called a decoupled market or economy.

In the aftermath of the recession, the concept that emerging markets around the world no longer need to depend on US demand to stimulate economic growth is an example of economic decoupling. While emerging markets were once dependent on the US economy, many analysts now argue that some emerging markets, such as China, India, Russia and Brazil, have become important markets for themselves. goods and services.

The argument for decoupling indicates that these economies could withstand a failing US economy. China, for example, draws almost 70% of its foreign direct investment (FDI) from other emerging countries in Asia and also invests heavily in companies producing raw materials on its continent.

By accumulating foreign exchange reserves and maintaining a current account surplus, the country can launch a fiscal stimulus in the event of a global slowdown, thereby dissociating itself from the advanced markets.

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