What is Decoupling and When Does it Occur?

Decoupling is a situation in which a security’s prices or asset returns differ from their expected pattern. Different assets classes with certain behavioural similarities are expected to have similar performance patterns. However, when these behave contrary to their usual correlations, a decoupling is said to have occurred. 

What is the definition of Decoupling?

In layman terms, decoupling indicates the creation of gaps. In finance terminology, decoupling occurs when different asset classes, or even markets that generally show positive correlations, begin to move in opposite directions.

For instance, if two asset classes often rise and decline together, but they suddenly begin to reflect different behaviours that seem contrary to their regular expected movement patterns, decoupling has occurred. Thus, we may notice the price of one asset class rise while the other declines. This means that the different asset classes that often move together have been decoupled.

Decoupling of financial markets

Within financial markets, various asset classes may be positively correlated with each other. This means their values often move in the same direction, although at a different pace. The larger the correlation, the closer the movements of asset values.

When the correlation between the two assets is equal to 1, the values of both the assets move together in most situations. For instance, oil and natural gas prices are correlated. So, when oil price rises (falls), the natural gas price also correspondingly increases (decreases). However, decoupling takes place in case the prices of two positively correlated assets begin to move in opposite directions.

Decoupling is applicable to different markets just as it can occur among asset classes. As developing countries see their economies grow, their dependency on major markets such as the U.S. becomes less. Thus, in an economic scenario, emerging markets are said to be decoupling from the matured markets.

Decoupling among economies

Decoupling can also take place among economies. Take, for example, decoupling of markets that took place during the 2008 financial crisis. Most often, markets are correlated with regard to growth. As against this tendency of markets, the financial crisis in 2008 resulted in a decoupling of markets and economies. The financial crisis gradually diluted across all global markets and resulted in a global recession although it had originally started in the United States. 

In some economies, growth of the emerging businesses is often dependent on the growth of large set-ups such that if the large organisations start earning profits, the emerging businesses follow suit. However, in case an emerging business does not have a dependence on a larger business as far as profits or losses are concerned, decoupling has occurred.

During the COVID-19 shutdown, the U.S. economy experienced a sharp slowdown. The country’s GDP fell as the unemployment rate spiked. After an initial jump, the U.S. stock performance recovered much sooner than the economy. The equity market decoupled from the economy.

How does decoupling work?

In financial markets, the relationship between two or more assets is often determined using correlation. If assets fall or rise together, they are known to be correlated. 

Usually, while making investment decisions, investors and portfolio managers prefer to have a diversified portfolio such that the investments or assets do not show signs of correlation. Thus, if an investor allocates his/her investment in a diversified portfolio, even with the fall in the value of one investment, the other investment does not follow suit.

Conclusion

Decoupling happens when markets with high positive correlations start to move in opposite directions. Decoupling can also be in reference to the differences between formal policies and actual practices, followed by organizations. It may result from a conflict of interest. Economic decoupling happens when an economy can grow without causing more environmental pressure or damages.

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