Tuesday, January 8, 2008

2008 Themes: A Less Correlated World Part I – Decoupling

The political scene today is littered with the word Change, as Barack Obama captures the high ground on this issue. So, too, have the markets embraced the C word. Unfortunately, it is in the form of an economic change for the worse.

Yet, there may be another way to view the changing economic and investment environment, one that investors can more profitably exploit if my following thesis turns out to be correct. The change I am speaking of is a change in the degree to which economies and markets are correlated.

Over the past decade, markets, sectors, and even styles have become more highly correlated. I have noted this issue in previous blog postings. However, high correlations are not just the domain of the investment markets. As economies have become more interconnected they have, as a result, become more highly correlated.

All this may change this year.

Correlations may diminish this year driven by two forces – one economic, the other financial. In the case of our globally interconnected world, a change from high correlation may occur in the form of decoupling: most notably a lessened economic effect emanating from the US.

Granted, decoupling may not result in a significantly lower correlation as economies are influenced by each other to a large degree. However, decoupling may prove to be more prevalent than many think as policy actions undertaken by various other global actors, such as China, will likely produce stronger domestic demand thereby delivering the sorely needed non-US consumer demand to sustain global growth.

If so, then a US recession (or, more likely, a growth recession – growth below potential) will not have the same effect on global growth as it has had in the past. In my opinion, decoupling is not just possible but probable for two primary reasons.

To begin, the financial health of most economies is quite strong. For example, the current account balances of nearly every emerging market economy is positive. In the past, such economies have been a source of economic global turmoil. That is not the case today. Moreover, Eurozone economies are, for the most part, also in good economic shape.

As a result, containment of the pain in the US will likely be limited to domestically oriented businesses while the more globally oriented will reap the fruits of globalization and the global growth story. In this regard, what may be lost to some is the fact that businesses that serve a true global audience via the Internet may also experience positive economic results which will help minimize the damage of a credit derivative inspired economic contraction.

A second factor that will likely play out this year is the Olympic games to be held in China this summer. It is hard to imagine that the leaders and policy makers will not pull out all the financial stops to ensure a rosy picture.

As for the US, the damage emanating out of the credit derivative fiasco will almost certainly run its course over the first half of this year. Yet, given the political realities of a major election year, it is hard to see our government exercising an electoral death wish and not act to assist the US economy work its way out of what amounts to a financial, not economic, crisis. To the naysayers I say, the policy tool kit contains many more instruments than you are giving it credit for.

Investment Strategy Implications

There is a considerable amount of skepticism regarding decoupling. And that skepticism is deserved. After all, the world has function a certain manner for just over a century. Yet, as is the case with the US political scene, meaningful change may be occurring below the radar of many investors. Globalization, the Internet, and financial innovation are just a few examples of a changing world.

Many are uncomfortable with change. For change means a disruption of the status quo. Ways of life are constructed around the status quo, as processes and systems enable the early adopters to gain competitive advantage and the spoils thereof.

Yet, change, for good or ill, is the one constant in life. Recognizing it can produce alpha.

Note: Tomorrow, in Part II, I will explore the issue of lower correlations between and among markets and sectors.

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