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Seeking Alpha has an interesting article by Geoff Considine, on the performance of equities in emerging markets over the past three years.

Geoff’s article made the following observations:

1. The hypothesis that emerging market economies were self-sustaining and hence their markets will be decoupled from developed markets was proven to be egregiously wrong.

2. Emerging markets are likely to continue to be strongly correlated with developed markets, with correlations increasing.

3. The Beta (a measure comparing the magnitude of moves) is likely to come down from the historical levels.

The decoupling hypothesis was put to test last year and it failed miserably. However, there were distinct divergences when it came to decoupling of the markets versus decoupling of economies, especially when it came to India and China. In this article I explore some of the underlying dynamics which drove that behavior and what investors should be conscious of when making investments outside the US.

When Economic Decoupling does not translate to Market Decoupling

The major Asian economies of China and India continued to post positive growth. India benefited since it is not an export driven economy; the Chinese government put its vast hoard of cash to work to increase focus on domestic consumption when exports were crashing. These Asian giants now have domestic markets of a size large enough to dampen the effects of a global slowdown. As a result, these economies continued to outperform the developed economies by the 4-8% margin observed in the last decade. Their performance during this period is a vindication of the decoupling theory; but only on the economic side.

When it came to the equity markets, both the Chinese and Indian equity markets suffered major losses, often exceeding those of the developed markets. This divergence in relative performance between the economies and markets was a direct result of reduced risk appetite from investors in developed economies.

The Marginal Buyer: Foreign versus Domestic

The run-up in the equities of emerging markets was driven by investors in developed economies rushing in to cash in on the growth in the emerging markets. Apart from the increased risk appetite during the period of low volatility in the middle of the decade, many foreign investors invested in the emerging markets because traditionally these markets were seen as less correlated to the their domestic markets.

However, thanks to the size of the foreign investment, they increasingly became the marginal buyer of equities, overtaking domestic investments from the emerging markets. Geoff writes:

From 1990 through 2000, only 20% of funds flowing into mutual funds went into foreign-focused mutual funds. By 2007, the flow of money into foreign funds was twenty times higher than the flow into domestic funds (John Bogle provides these stats in Enough (2009)).

The same foreign investors who could not get enough of the emerging markets in the middle of the decade ran for the exits as risk appetite started waning about 18 months ago. As a result the equity markets of these countries showed high correlation (and no decoupling), with a higher Beta magnifying the losses.

Future Trends

Investors seeking diversification in their equity portfolio should realize that emerging markets no longer remain the undiscovered, uncorrelated class, which help diversify a portfolio. Even when their economies continue to grow and become less dependent on exports, the markets will continue to attract capital from the developed world. Hence, any change in risk appetite in the developed world will continue to affect the performance of these markets.

Outperformance: Perhaps Yes

There is a case to be made of relative outperformance of these markets compared to the developed world. Part of the reason is going to be the painful lesson learnt by investors that even developed markets are not averse to systemic risk, whether it is the sub-prime crisis in the US or the Eastern-European loan crisis in Europe. The persistence of economic growth illustrated by India and China during the past year, will also increases the confidence level in these economies’ ability to tolerate shocks.

This is likely to result in a greater in-flow of buy and hold investors into these markets instead of the hot money investors. The appetite for risk of the local investors will also grow as these economies recover their growth rates. This is likely to reduce the Beta or the volatility of returns from these markets.

Is Market Decoupling Ever Possible?

Any change in correlation (the true decoupling) between these markets will have to wait till their economies grow to a size:

1. Where domestic investors dwarf out foreign investors as new investors in the equity markets.

2. Domestic consumption dominates export as driver of economic growth

At that point these markets will follow the lead of their local economic conditions (which are likely to be influenced by the global situation), and not just the risk appetite of investors in the developing world. This is unlikely to happen in the near term in the more popular emerging markets.

Frontier Markets: Best Bet for Decoupling

Investors looking for equity markets which are decoupled from the developed world will have to step-out of the comfort zone of the popular emerging markets and into undiscovered emerging markets, the so called frontier markets. These markets include countries all over the world.

These markets are yet undiscovered by mainstream investors in developed markets. So for at least in the short term, these markets may not be affected by a rush for the exits by foreigners. Many of these markets have the same characteristics of the major BRIC emerging markets in terms of potential for organic growth and the ability to benefit from rising commodity prices.

If risk appetite does return, it is likely that the frontier markets will act like the emerging markets of the last decade. Since the size of these markets is small, they are likely to show higher Beta, and outsized returns initially. But they will carry extreme down-side risks; similar to the down-side illustrated by the equity markets of the major emerging markets over the past 18 months.

Seeking Alpha has several articles on investing in frontier markets via ETFs, Close End Funds, and ADRs. Right now I would avoid investment in Eastern Europe and focus on countries which will benefit from growth in commodities and raw-materials. However, investors should keep in mind that except for the most aggressive, risk-taking investors, these small markets should be a small part of your equity portfolio (< 5%).

Disclosure: Vikram has some exposure to international markets via mutual funds.

Source: Global Decoupling: Distinguishing Between Economies and Markets