Did somebody say ''decoupling''?

There is a growing worry for investors as they head towards the second half of the year -- will governments'' increased appetite for budget cutting knock the nascent global economic recovery off track?

 

The answer might come down to a somewhat discredited concept, the "decoupling" of economies that sees some driving forward while others lag. That was what was supposed to happen as the sub prime financial crisis built, but it didn’t.

 

Many investors have assumed for some time that while the debt crisis in Greece and mounting fiscal problems in other peripheral Euro zone countries is a serious matter, the long-term outlook for world economic recovery looks good.

 

Now, however, there is a rush by governments to get their accounts in order, a kind of synchronised austerity that threatens to crimp the ability of economies to spend their way towards growth.

 

This challenges many assumptions among investors, who have hung on to a belief that equities will recover from the current correction because of economic growth.

 

The latest to join the austerity movement is Germany, which unveiled a package to deliver savings of 11.2 billion euros ($13.48 billion) next year, lower this year’s budget deficit, and increase savings to 19.1 billion euros in 2012, 24.7 billion euros in 2013 and 26.6 billion the following year.

 

Britain, too, has begun cutting its budget, so far aiming to save 6 billion pounds ($8.74 billion) this year. 

 

The two moves prompted independent investment advisers Lombard Street Research to refer in a client note to an "Anglo-German stupidity shoot-out" a veiled reference to past football matches between the two on-field rivals.

 

"Anglo-German fiscal policies virtually guarantee a fresh European recession, possibly a medium-term depression," strategist Charles Dumas wrote to his clients.

 

On One Engine

It is at this point that decoupling comes into view, the idea being that while Europe might struggle as a result of its debt austerity tango, major economic engines such as China and the United States will carry on growing.

 

"In effect, the global economy has lost an engine with Europe," said Michael Dicks, head of research and strategist at Barclays Wealth. "It means you are still flying, but it is not as balanced. It is a trickier ride."

 

China showed some of its resilience in the past week, reporting a near 50% annual surge in exports in May. That was enough to keep equity markets rallying from recent lows.

 

World stocks were up 1.6% for the week, heading towards one of their better performances of the year. China was also behind what was shaping up to be the Euro's best week of 2010. The single currency has fallen around 15% against the dollar this year but was up some 1.7% for the week.

 

This was partly due to comments from Dai Xianglong, chairman of China’s $114 billion National Social Security Fund and a former governor of the country’s central bank.

 

His view that the Euro would gradually stabilise was taken as a sign that China is not about to cut back on its Euro reserves, a fear that has risen as the Euro has fallen.

 

As for the world’s largest economy, US data has been generally positive. The coming week will test this with a series of housing reports including permits and starts.

 

Europe’s situation meanwhile should get an airing at the mid-year European Union leader’s summit in Brussels.

 

Spilling Over

All this is macro, but investors also have to struggle at the moment with a micro crisis that of BP and its environmentally and economically damaging oil spill.

 

The problem for investors when it comes to BP is a kind of eggs-in-a-basket one. It is so large a part of many benchmarks that a sharp stock fall or a suspension of dividend has way more impact that it would have if it were another company.

 

Just one example, courtesy of Evolution Securities, is that a suspension of BP's dividend would lowers the total yield return for UK stocks to the same or a bit less than that for UK gilt .

 

This could prompt not just a flight from BP, but also from British equities in general, many of which are big names held widely by global investors.

 

The damage being wrought on portfolios by BP's decline, meanwhile, could prompt large institutional investors to review their holdings again to make sure they are not too behooving to one company or sector.

 

All this will be a focus in the week ahead and could mean more volatility.