The death of the 'decoupling' theory?
By Conrad de Aenlle Published: January 25, 2008
Traders work on the floor of the New York Stock Exchange in New York, U.S., on Tuesday, Jan. 22, 2008. U.S. stocks pared their biggest decline since 2002 after the Federal Reserve's emergency rate cut helped mitigate concern the economy is slipping into recession. (Jin Lee/Bloomberg News)
No one can say how much has been lost by investors basing decisions on unproven strategies that work in theory, but the amount has grown significantly. As trillions of dollars were wiped off the value of global stocks this week, "decoupling" became the latest big idea to shrink dramatically when tested in the real world.
Decoupling holds that European and Asian economies, especially emerging ones, have broadened and deepened to the point that they no longer depend on the United States for growth, leaving them insulated from a severe slowdown there, even a fully fledged recession. Faith in the concept has generated strong outperformance for stocks outside the United States - until now.
As opinion began to solidify after the start of the year that a recession, or something close to it, was likely in the United States, stock prices accelerated their declines, with the selling intensifying early this week. Contrary to what the decouplers would have expected, the losses were greater outside the United States, with the worst experienced in emerging markets and such developed economies as Germany and Japan.
Exports make up especially large portions of economic activity in those places, but that was not supposed to matter anymore in a decoupled world because domestic activity was thought to be so robust.
Decoupling was all the rage early last year when international financial markets all but ignored the increasing turmoil in the U.S. economy and stock market. Investment advisers point out, however, that the segments of the U.S. economy that were showing wear and tear then were those to which the rest of the world would never be heavily exposed. That is no longer true, they say, and markets are responding accordingly.
"Decoupling is yesterday's story," Stuart Schweitzer, a global strategist at J.P. Morgan Private Bank, declared. "Last year, when the U.S. slowdown was driven almost entirely by housing, it made sense that the rest of the world kept right on going. Housing is a domestic story, plain and simple.
"The nature of the slowdown has changed in two key respects. The credit crunch that began in midsummer is not just a U.S. phenomenon; the rise in risk aversion is global and will have an impact on credit terms and availability everywhere. And we're finally seeing evidence that the U.S. job market is losing steam and consumer spending is slowing."
True believers in decoupling have ignored another theory that appears to be logically inconsistent with it, has been popular for far longer and, most important, has been shown to work in real life. Remember globalization?
"If anything, global interdependence of economies is rising, not falling," said Jeff Applegate, chief investment officer of Citi Global Wealth Management.
"The notion that the U.S. can go into recession with no negative knock-on effect in the rest of the world doesn't hold up."
Andrew Foster, head of equity research for Matthews International Capital, a specialist in Asian markets, contends that it is possible for globalization and decoupling to coexist. In fact, one gave rise to the other, he said. It was only through economic liberalization that the juggernaut economies of Asia were able to grow as fast as they have, allowing for the development of conspicuously consuming middle classes.
"The irony is that these economies are more coupled with the rest of the world than they ever were in the past," he said. "That's why they're so strong, and that has allowed them to become more independent."
The new Asian consumers may not be able to compensate for all of the exports that would be lost during an American recession, Foster said, but some of the companies that serve their needs might still do all right for themselves. The true decoupling may be not so much between the United States and the rest of the world as between segments of the global economy that cater to the burgeoning nouveau riche in emerging economies on one hand and most other commercial sectors on the other.
With the United States apparently tipping over into recession, Foster is looking to fill his Asia portfolios with the first type of businesses, as long as they have not been bid up to unreasonable levels already. A couple of pockets of opportunity that he finds are Chinese insurance companies and Indian health care providers.
"I like companies that don't derive their fortunes from products, services and especially commodities dominated by the global business cycle," he said, although he declined to furnish examples.
Valuation is also critical for Michael Avery, chief investment officer of Waddell & Reed and a professed believer in decoupling - up to a point. He noted that the concept began to pop into the heads of professional investors, including his, during the last U.S. recession, in 2001-2002, although it had not yet achieved buzzword status.
"A lot of people in our business were thinking about where the world was going to head in a post-9/11 environment," Avery recalled. "The U.S. economy had slowed dramatically in 2001, and you had places in the world like China and India that continued to grow at mid- to high single digits. That set in motion the thinking that the U.S. might not be the leading economic force going forward."
But while he accepts the basic idea of economic decoupling, he is not fanatical about it as an investment theme, at least not now. The emerging world will grow faster than the United States, in his view, but Avery doubts that sufficient growth can be achieved to justify the valuations being put on companies in those markets by the new wave of decoupling adherents.
"The big difference in 2002 is that not many people placed bets on that outcome, so there wasn't much risk," he said.
"Now I can go anywhere, and if I talk about China and India and the emerging middle class, they all nod their heads. It's a huge difference from five years ago."
Avery still finds value in some domestically oriented sectors in Asia, as well as in Middle Eastern markets that continue to benefit from one key export, crude oil. He noted that while exports to the United States of less viscous products may be at risk, the growth of middle-class spending is promoting a healthy expansion of trade within the emerging world.
Avery made a big bet on declining share prices late last year when he sold short derivative contracts tied to benchmark stock indexes. But his Ivy Asset Strategy Fund has substantial holdings in such plays on emerging-market domestic demand as the phone company China Mobile; Veolia Environnement, a French producer of water treatment systems, and Las Vegas Sands, an American hotel and casino operator expanding into Macao.
In addition to selling stock index futures, Avery has about 10 percent of his portfolio each in gold, cash and Treasury bonds as hedges against the uncertainties and jolts that would accompany a U.S. recession.
Tim Guinness, chairman and chief investment officer of Guinness Atkinson Asset Management, is another whose objection to decoupling is more a matter of how it works in practice.
"I'm a moderate decoupling believer," he acknowledged. "I'm in the camp that believes that China is rapidly moving from being dependent on exports to the U.S. to enjoying a virtuous circle of rapidly rising incomes for Chinese consumers and very strong momentum behind internally driven growth."
There is momentum in China's stock market, too, he noted, but in a different direction. Perhaps the biggest beneficiary of decoupling is giving back much of its enormous gains of the last few years as investors break faith with the concept.
"I prefer China, but not today," Guinness said. "The next few months will see a continued retreat in China-related stocks. The correction already has been very pronounced."
He prefers less bubbly stock markets in emerging economies where domestic demand is strong, like South Korea and Thailand. Individual stocks that he favors include PTT in Thailand, Singapore Petroleum and Cemig, a Brazilian hydroelectric company.
Applegate, at Citi, finds stocks better value than bonds. He particularly likes global banks and stocks in Europe and emerging markets generally, although he considers China and Hong Kong fairly pricey.
Bonds and equities have experienced sharply diverging fortunes recently. Many stock markets are more than 20 percent below their 2007 highs, while yields on government bonds have plummeted, sending their prices aloft.
Movements in both markets suggest that investors are factoring a global recession into their thinking, a development that could set the stage for the next rally in stocks and render the decoupling argument moot.
Another theory, with a proven track record, states that stocks should be bought once the economy is recognized to be in recession. By then, share prices account for all or most of the bad news, the authorities have taken steps to correct imbalances and a recovery is often imminent.
"Play the movie forward," Applegate said. "If the economy is going to soften globally, then can you expect more central bank policy response? The answer is a resounding yes."
In such conditions, he said, "you should have more of a preference for equities over bonds."
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Nik Zafri's Comments : I've been saying it!!!
