Wednesday, December 05, 2007
Macro Man had to chuckle this morning when he read a note from Goldman Sachs declaring "victory" on the research group's decoupling thesis and warning that 2008 may be the year of "recoupling." De-coupling, for the uninitiated, is the theory that the rest of the world can shrug off US domestic economic and financial weakness and continue to party. Re-coupling is the notion that the rest of the world will finally catch cold fom the US housing market's sneeze.
Long-time readers of this space will recall that Macro Man has long thought the theory was poppycock. The case for decoupling has basically been rooted in the notion that US housing will sink the US economy because...well...it just has to, while the rest of the world appears to be doing jolly well courtesy of the BRICs.
The case against decoupling has been, by and large, just about every piece of empirical evidence that Macro Man has looked at. Lost in the hubbub over the US housing market is the fact that, through the first three quarters of the year, US economic growth has been considerably quicker than it was in 2006.
The average annualized quarterly growth of the US economy in 2006 was 2.6%. So far this year, it's been 3.1%. Even if the US economy grows at a measly 1% rate this quarter, 2007's growth rate will match that of 2006. A big reason why, of course, will be net exports. There seems to be an off assumption amongst commentators that the links between the US and the rest of the world flow only in one direction. This of course is patent nonsense, and a key reason why decoupling has been a myth is that the US has been kept afloat by strong demand elsewhere in the globe.
Looking at Europe as a comparison point, average quarterly growth so far in 2007 has been 2.4%, which is lower than both the equivalent US figure and the Eurozone's 2006 average of 3.2%. Hard to see the decoupling there. True, China has been growing at a faster clip in 2007 than in 2006. But again, isn't that we've observed so far from the US?
Similarly, inflation rates are at decade highs in the Middle East, Germany, and many Asian countries. Energy and food prices are an obvious driver there, and they are also now putting upward pressure on US headline inflation as well. Given that everyone in the world needs to eat, and fuel consumption is necessary for economic activity, it's difficult to see how the basic cost of living can decouple across regions in terms of trend (magintudes can differ because of different consumption basket weights.)
As for financial markets, the volatility observed since August has made a mockery of the decoupling thesis. If subprime and housing are US problems, why are interbank spreads blowing out across all developed markets? Why did European money market funds hit the wall in July/August? Why is Northern Rock in the UK on the brink of nationalization?
Moreover, cross-market correlations are remarkable high. Consider the case of two fundamentally unrelated financial market prices, the S&P 500 and the NZD/JPY exchange rate. In 2007, the r-squared between these two has been 0.53, a remarkably strong relationship. In contrast, the r-squared in 2006 was 0.004. In 2005, it was 0. In 2004, it was 0.004. In 2003, 0.002. How, then, does this represent "decoupling"?
Regular readers will recall a periodic analysis that Macro Man performs on a typical "balanced" portfolio in G3 markets. He looks at the rolling risk-adjusted return in the US, Europe, and Japan of a portfolio comprised of 60% equity, 35% bonds, and 5% cash. The results for rolling 1 year return:risk ratios ending last month are shown in the chart below.
At last, we have evidence of decoupling! Only it's been Japan, the great recovery favourite of recent years, that has decoupled from its major-market brethren. Ironic, isn't it, how the country perched on China's doorstep is the one with the lousy growth and asset returns.
Perhaps, though, the world's central banks have been drinking the "de-coupling" Kool-aid. Until yesterday, the Fed was the only developed market central bank to cut rates since the crisis began. However, the Bank of Canada joined its southern neighbour yesterday, surprising markets (or at least economists) by trimming rates 0.25%.
What makes this ironic is that independently-calculated leading indicators are actually more favourable for North America than they are for Europe, where there's been no easing to date. The OECD leading indicators are shown in the chart below, calculated in Macro Man's preferred 6m/6m change format.
Observe how the US and Canada leading indicators are showing a firmer rate of growth than those in the UK and Eurozone, yet it is the latter two which have yet to ease policy. That of course could change tomorrow, given that another set of lousy house price data in the UK (what's that about de-coupling?) and a poor services PMI make trimming the BOE base rate highly advisable.
So congratulations to Goldman and most other commentators on their "prescient" de-coupling view for 2007. It's a pity that the call didn't seem to yield profits in August and November, as those pesky asset-market correlations all seemed to trend toward 1 during times of stress. Ironically, just as GS is calling for global economic "re-coupling" in 2008, Macro Man is wondering if it won't be the year of financial market "de-coupling", where relative value and spread trades trump the "buy 'em all" and "sell 'em all" strategies of the "de-coupled" 2007.
Macro Man can of course be wrong in his view, but that's the wonderful thing about P/Ls as a method of keeping score. It's pretty hard to declare victory when your P/L has just handed you a big fat loss.