Wednesday, December 05, 2007

What decoupling?

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.

14 comments:

Peter said...

i've been 'polling' people on this decoupling story ever since it surfaced at GS .. and noone really believed it
the theory was, that the IMPACT of the housing induced slowdown will be offset by the BRICs.. well that means the recoupling should now be in its early stages, but instead we are already recoupling ???

i think, it just shows what load of b*ll*cks sell side research occasionally delivers
my consp.theory is that seeing a downturn, in order to get attention and affection, GS came up with the decoupling idea, in order to be able to go around with something worthy of attention and (BRIC)asset bullish..

i just wonder really, what their next BIG IDEA is...

Anonymous said...

Yes, GS joke and they joke well, but, then again, they are a hedge fund and are probably doing their best to fool their clients (that's how the best trading opportunities come up btw...). You might wanna take a look at the MS 2008 Global Interest Rate outlook (out yesterday). They are taking a look at the "de-coupling" story: as in 2003-2006 were the years when the risk-loving, barely-out of-college monkeys ruled -- you buy risk with no regard to consequences... 2008-2010 might well be the years when the "fundamentalists" rule, where people who do their homework on relative value and fundamentals win. I think you might need to scrap that "beta" portfolio after all...

i^i

W.Edwards said...

As a Canadian (although an ex-pat working in a foreign financial market), the sudden rate Bank of Canada rate decline was not a surprise to me. All of these "lead" economists need to spend some time looking beyond their models to see what's happening in the real world.

For example, Canada exports a very high percentage (70%+) of what it produces, mainly to the US. The recent episode where the CDN$ hit all time highs at $1 CDN = $1.1 USD (30% stronger than what it was 10 months ago!!) has had a significant effect on Canadian exports. But an even bigger issue is that 80%+ of Canadians live within 150 miles of the US border. When the CDN$ hit par with the USD (a very important psychological barrier), Canadians flooded over the border in droves looking for bargains on the US side. As such, Canadian retail has been hammered over the last few months, having had to apply 30% price reductions on a wide variety of goods to "match" US prices (nb: largely the reason the BoC noted reduced inflationary pressures as the reason for the decrease). The brakes on the Canadian economy have been applied hard over the last few months and no leading indicators are quick enough to pick up how dramatically the landscape has changed.

Anonymous said...

macro man -- shouldn't you deduct out net exports to get a sense of how much of an impulse us growth is transmitting to the world? US import growth has certainly slowed, w/o so far (the goldman the world may recouple in 08 argument seems like a huge hedge) slowing global growth that much. my view on this is that asia replaced the us as a key export market with europe, and that process is on its last legs.

bsetser

Macro Man said...

Glad to see that I'm not the only cynic out there. I don't even know that it necessitates a downturn to get GS and/or others to write headline-grabbing pieces. As a former sellside researcher, I feel qualified in claiming that much of the research out there is designed to be interesting rather than correct.

W, it seemed quite clear from the comments out of Canada that when USD/CAD went below par and appeared to accelerate lower, there were a lot of unhappy bunnies in the great white north. As you note, the subsitution effect is alive and well near the border. I thought that there was a pretty good chance that BOC would cut, but then again given the 10% rally in USDCAD off the lows, I figured it was in the price.

Brad, subtracting out net exports is exactly what you don't want to do, IMHO. The traditional "when the US sneezes" school of thought is predicated on an export link, which eventually feeds through into domestic demand in the ROTW some time later. The point I am trying to raise is that the export link cuts both ways, and that the rude health of much of the rest of the world has kept the US "cold" from developing into pneumonia. I think if one looks purely at domestic demand, the global linkages were never that strong to begin with.

Anonymous said...

What about that other wonderful "de-coupling" story that Manhattan real estate is immune from the national housing downturn? Perhaps Goldman can "educate" us about that one too!

ukhousingbubble said...

UK Housing Bubble .

Check this story out:

Revealed: how UK banks exploit charity tax laws .

UK Banks have been using "charitable status" to offload mortgage debt from their balance sheets. Moreover, the amounts are huge.

Where is the outrage?

Alice
UK Housing Bubble .

Macro Man said...

I suspect that the outrage eloped with the outrage over Gordon Brown's systematic raiding of John Q. Public's pay packet over the last decade, with nothing to show for it other than worse education, worse public health, worse public transport, and a hefty bill for military expenditures.

prophets said...

MM

2 q's:

What kind of sell side research did you do before moving to the buyside?

Which sell-siders do you prefer most or who would you recommend (if I wanted to read 1-3 guys regularly just for Macro thoughts) for a bottoms up equity hedgie?

thx

Macro Man said...

Prophets, I was a bank currency strategist in the late 90's.

As for sell side recommendations, let me preface them by noting that I do a lot of my own research, and that as a result I tend to read a lot more economics than strategy.

My taste in strategy therefore tends to the short and sharp rather than lengthy 'weeklies.'

My favourite guy, and a chap who has in some ways influenced my style in this space, is Fred Goodwin, a.k.a. "Mr. Prop", at Lehman. He is primarily a fixed income guy who also does currencies and equity indices. He also runs a model portfolio with P&L, which adds a dose of credibility (and angst on his part.)

For news round-up, there's a London sales guy at UBS called Andy Lees who follows a lot of markets and writes up salient or interesting points on each every morning.

Finally, I actually don't think that the GS global markets daily is a bad product. They do recommend trades (though without P/L calculation); I generally rely on my sales guy there to recommend when its worth reading.

Hope this helps!

CV said...

Hi MM,

Just rushing in a bit quick here. I COMPLETELY agree.

The traditional discourse of de-coupling as it was originally envisioned is basically way off compared to what we are seeing. Rather, what we have is 're-coupling' but the world economy remains coupled as ever before.

Also, the main canidates for de-coupling (i.e. Japan and Europe) hardly look as if they can muster the pressure. Even if liquidity moves accordingly with the de-coupling/rebalancing thesis.

Claus

Yaser Anwar said...

MM-

May I ask how you came up with the rolling risk/reward rations?

Thank you in advance. Great post.

Macro Man said...

Yaser, the data was comprised of total return data for the MSCI equity and bond incides for the relevant regions, plus 3m LIBOR as a cash return proxy. From there it is easy to calculate weighted monthly returns for each market, and then rolling returns an d volaitlities- and with them the ratios.

Yaser Anwar said...

much appreciated MM