Decoupling in finance refers to an event where two or more financial assets that were once in sync begin to separate and move independently from one another. The term can be applied to several different scenarios, such as individual investments, asset classes, and economies as a whole.
Certain asset classes tend to move together in unison, i.e., when one experiences an increase in value, the other(s) tend to experience the same. However, when a policy change or similar event takes place, and the assets start to move separately, it is said to be “decoupled.”
Table of contents
- Decoupling occurs when two financial assets, such as stock and bonds, are correlated in their performance and begin to move independently.
- It can happen with individual assets, asset classes, and even entire economies.
- The tensions between the U.S and China can lead to decoupling.
- When it occurs, it can have a profound impact on investors. Depending on the event’s severity, investors could lose out on significant amounts in capital gains.
How Does Decoupling Work?
Decoupling often occurs when there is a difference between policies’ formulation and implementation. To understand this idea better, we can break down the term into two parts.
“de” = meaning to do or move the opposite.
“coupling” = means to connect or to pair together.
When we put both together, “decoupling” means that something once connected or paired together is moving in opposite directions.
For example, think about the commodity asset class for a moment. When prices of a commodity like gold begin to rise, the gold mining stocks also rise with an increase in their value. In this sense, gold and gold mining stocks correlate with one another, i.e, they are moving together at approximately the same time.
Gold and gold miners are an example of a positive correlation between assets because they move in tandem. However, assets that move in opposite directions can also be correlated. For example, take gold and the U.S dollar into consideration. These two assets tend to move in the opposite direction of one another and hence are negatively correlated.
When assets such as gold and gold miners or gold and the U.S dollar stop moving in correlation to one another, they are decoupling. It can happen due to random political events, economic crisis, environmental disasters, or other external factors. For example, the value of gold may slowly start to be less dependent on the U.S market, and therefore the correlation fades, and decoupling starts.
Asset correlation and decoupling can happen on a larger scale as well – such as when the economies of two or more countries that previously moved in synchronization begin to diverge and proceed to move independently.
Examples of Decoupling
Decoupling happens all the time in finance for various reasons. Let’s look at past events where this has occurred to understand the term better.
Example 1: Gold & U.S Dollar
The U.S dollar and gold are notorious asset pairs that negatively correlate with one another. For example, when the value of the U.S dollar is rising, you can typically find the value of gold falling and vice versa.
The U.S dollar and gold have always had a relatively strong negative correlation. When the U.S dollar was falling to new lows in 2008 in the wake of the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors., gold enjoyed a steady increase in value as investors were looking for a safe place to store their money.
However, the assets started to move independently from one another at the start of 2010. The decoupling lasted several months until mid to late 2010 when the assets continued to negatively correlate with each other. The pair stayed in a negative correlation until mid-2014 when the U.S dollar experienced an increase in value, and gold did not follow the same trajectory.
Example 2: Developed & Emerging Markets
The developed and emerging financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces. are other examples that can be in a powerful correlation and experience decoupling. For example, the two financial markets were following each other at the time of the global financial crisis as all the countries were recovering from the devastating effects.
Both emerging and developed markets moved in synch with one another until 2018. In late 2017, emerging markets’ value began to rise significantly. Developed markets were also increasing in value but not nearly as much as the emerging markets. The trend persisted till the end of 2019.
Decoupling in China
In the past few years, the tension between the U.S and China has heightened. This has led many to believe that the two economic giants will begin decoupling from each other.
Former U.S President Donald Trump repeatedly mentioned how the U.S government was going to retaliate against China and force sanctions over their supposed involvement in the Coronavirus pandemic and their handling of the Hong Kong Autonomy. Trump had signed the Hong Kong Autonomy Act on July 14, 2020. This has made it harder to do business with companies in China.
In return for the new sanctions, China fired back with a few sanctions of their own. This allowed Chinese companies to complete business, as usual, ignoring the U.S sanctions that they put into effect.
This tension between the two countries can cause the decoupling of assets and the economies as a whole. Moreover, the restriction of certain U.S technologies alone can profoundly impact China’s financial markets.
How it Affects Investors?
From an investor standpoint, decoupling can have profound impacts on their investments. According to an analysis from the U.S Chamber of Commerce, if the U.S and China decoupled from each other, investors in the U.S could lose out on $25 billion in capital gains per year and a one-time GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period. loss of nearly $500 billion.
On the other hand, some investors may see this as an opportunity and take advantage of the situation by aligning their investments accordingly.
Applications of Decoupling
Decoupling can occur in several scenarios, including:
#1 – Financial Markets
Decoupling can be applied to several different scenarios within financial markets. As previously mentioned, it can occur with individual stocks, asset classes, and entire economies.
Stocks, bonds, commodities, indexes, etc., can all be correlated at one point in time and then begin to decouple from one another.
#2 – Eco-Economic
You can also apply decoupling to situations where an economy can achieve economic growth while also decreasing the environmental impact. Typically when a nation can achieve economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period., it leads to harsher treatment of the environment, like burning more fossil fuels or consuming additional natural resources.
When an economy can achieve higher economic output and reduce its environmental impact, like using less natural resources or cleaning up waste, it is decoupling.
Frequently Asked Questions (FAQs)
Decoupling in economics means the trajectory of two financial assets in opposite directions that used to move in a correlated fashion before. Assets can be positively or negatively correlated with each other and can go in an independent direction all of a sudden. Economic decoupling can occur due to a variety of reasons. This term can mean different things in different contexts.
Improving economic growth through production often leads to the depletion of natural resources and puts immense pressure on the environment. An economy that is self-sufficient enough to grow without pressurizing its environment or paving the way for major environmental changes is said to be decoupled. This phenomenon is called eco-economic decoupling.
Decoupling denoted the divergence of asset classes from each other. Financial decoupling is important because it signifies the autonomy of various assets. It can have huge economic impacts on smaller and larger scales.
This has been a Guide to Decoupling in economics and its meaning. We discuss its working, examples, how it affects investors, and China-US decoupling. You can learn more from the following articles –