INVESTMENT RESEARCH AND TRADING

17 October 2008
WEEKLY RESEARCH NOTES

Decoupling uncouples
US baseball player, manager, and sage Yogi Berra once remarked that, Our Research
“a nickel ain’t worth a dime anymore.” In a similar vein it might be said that
superlatives ain’t quite as super as they were. The savage devaluing of
stock markets, currencies and entire countries has caused collateral State Street Global Markets, the
investment research and trading arm
damage to the power of language. Unprecedented and extraordinary are
of State Street Corporation, develops
two words that should generally be deployed sparingly. Yet in recent proprietary research using information
weeks they have seemed rather inadequate. aggregated from more than 15 percent
of the world’s tradable assets.
In the midst of these startling events it is worthwhile recording in detail just
how volatile markets have been over the past month1. This can be done By aggregating and analyzing the
by a straightforward analysis of the best and worst days for important holdings, flows and borrowings of
market indices over their history. The US S&P500, for example, has a institutional investors around the world,
daily data series stretching back to January 1964. Seven of the worst and the research provides unique insights
four of the best days have been recorded in the past month. Ten of the into institutional investor behaviour and
twelve highest closing readings of the Vix volatility index, which is a data its interaction with global financial
series that goes back to January 1990, were registered in the past three markets.
weeks.

These remarkable statistics probably come as no surprise given the State Street Corporation
pressure on the financial system and the dramatic intervention of
governments around the world. What is perhaps more noteworthy is the State Street Corporation (NYSE: STT)
recent performance of emerging markets, which have so far been is the world's leading provider of
relatively unaffected by the woes in banking. The MSCI Emerging Market financial services to institutional
index goes back all the way to January 1988. This period encompasses investors including investment
the Mexican Tequila crisis and Brazilian devaluation, the Asian currency servicing, investment management
crises of 1997-98 and the Russian debt default. Six of the twenty worst and investment research and trading.
days for the MSCI index have been recorded in the past month and one With $14 trillion in assets under
of the best. custody and $1.7 trillion in assets
under management at Septemeber 30,
No other period comes close to similar volatility, for example, only three of 2008, State Street operates in 26
the worst twenty days were recorded during the turmoil of 1998. The countries and more than 100
MSCI Eafe index of developed equity markets has fallen 42% year-to- geographic markets worldwide. For
date, but the emerging market index is down 50%. The solid sounding more information, visit State Street’s
BRIC (Brazil, Russia, India and China) index is down 57%. web site at www.statestreet.com.

Those pundits that expected emerging markets to decouple from their

peers in the developed world have unsurprisingly been rather quiet of Contact Information
late. The volatility of emerging markets has been accompanied by a
savage reversal of flows. In the month up to the Lehman bankruptcy on State Street Media Relations
15 September aggregate emerging markets flows were close to their long-
run median. Monthly emerging markets flows have since collapsed to the
> Carolyn Cichon +1 617 664 8672
7th percentile (flows higher on 93% of previous months in the 11-year
ccichon@statestreet.com
history of the Cross-border Equity Flow Indicator).

Even this picture masks just how bad things are in some areas of > Mary Bailey +44 20 7864 7075
emerging markets. That is because flows remain broadly positive for mbailey@statestreet.com
certain emerging European markets skewing the aggregate picture.
Monthly flows into emerging Asia are at record lows, lower than at any Editor
time during the financial crisis of 1997 and 1998 which saw the
International Monetary Fund bailing out Thailand, Indonesia and South
Korea. Monthly flows are lower than 5th percentile (flows higher 95% of > Andrew Capon +44 20-7864 7876
the time) in India, Korea (record low), Malaysia, Philippines, Taiwan, amcapon@statestreet.com
South Africa and Mexico.

1
Thank you to my colleagues at State Street Associates for sharing this data.
 Weekly Research Notes 17 October 2008

With flows into the developed market MSCI Eafe countries Chart 1: Volatility at unprecedented levels
also at all-time record monthly lows, it is clear that the global
pattern of flows is re-coupling. An optimist, if any still exist, Daily US equity and bond returns (from 1997)
might point out that such marked risk aversion is unlikely to
3%
persist. However, what underlies the re-coupling of flows
and prices is a macroeconomic backdrop that is 2%
deteriorating everywhere. 1%

US Bonds
Here are some measures of gloom from this morning’s 0%
newspapers. UK unemployment is rising at the fastest level -1%
for 17 years, US retail sales suffered their biggest fall since
2005, European car sales were lower in August than at any -2%
time in a decade and the Baltic Dry Index, a good proxy of Since September
-3%
demand for commodities, slumped to its lowest level since -12% -8% -4% 0% 4% 8% 12%
2003. Following the formal declaration of a US recession in US equity
March 2001 investors stayed risk averse. In 10 of the next
12 months State Street Global Markets’ Regime Map, a
pictorial representation of investor behaviour and the pattern Source: State Street Global Markets
of cross-border equity flows, pointed to either Riot Point or
Safety First. These are the two most risk-averse regimes.

Emerging markets tend to underperform in these regimes.

That is certainly the lesson from the 2001 US recession. Chart 2: Falling reserves further constricts liquidity
Between March and the end of the year the S&P500 fell
9.5%, but the MSCI Emerging Markets index slumped 29%. Emerging Asia (weighted)
This time around the travails of emerging markets also 40 FX reserve growth, 2001-2008
threaten to cause negative knock-on effects in developed 35
markets. The US consumer has been the main engine of
30
Asian export growth and this has in turn generated excess
foreign exchange reserves. These have been used to buy 25
%, yoy

US assets. 20
15
That source of global liquidity is also drying up as Asian
10
central banks use their reserves to defend their currencies
(Chart 2). This is particularly pronounced in South Korea, 5
Malaysia and India, where reserves fell by $19bn, $16bn 0
and $15bn respectively in the third-quarter. Decoupling was 2001 2002 2003 2004 2005 2006 2007 2008
always likely to be a fanciful idea in an interconnected world.
As Berra noted, “Even Napoleon had his Watergate.”
Source: State Street Global Markets

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