Decoupling: The Good, The Bad and the Ugly

Decoupling is back with a vengeance. The resilience of most emerging markets in the wake of the worst economic and financial crisis since the Great Depression is truly impressive. In addition, nobody can contest that stock markets in Shanghai, Bombay and Sao Paulo led the formidable market rally that drove global stock markets back to their pre-Lehman levels.

But what is decoupling really about? Is it about the economy or about markets? Is it short term or long term? Is it based on solid foundations or on fugitive impressions?

I believe there are three ways to consider the decoupling story: the good way, the bad way and the ugly way. Much like there were three antagonistic characters in that great movie from Sergio Leone. Each of them looking for a hidden treasure, each with a bit of information that he may or may not share with others, but none with the complete "story".

First, let us consider the ugly way. This version was the most common among naive analysts and traders before the financial crisis burst. It relied on the flawed assumption that emerging markets, and especially China among them, were becoming insulated from economic and political developments in developed markets, and primarily from developments in the United States. This was the argument behind the 200 or 250 USD per barrel of oil forecast that was popular in the summer of 2008. We all know how it ended up. Let us hope that this "ugly" version of decoupling is over.

Second, there was the bad way to view decoupling, as something that was essentially temporary and that did not rest on sound economic and financial foundations. This view was very popular after the market crash of October 2008. Sometimes, the same people that used to defend the "ugly" unrealistic version of decoupling turned to the complete opposite saying decoupling was dead.

And finally, there is the good way to think about decoupling, as a dynamic process of rebalancing the global economy from the hyper-dominance of the United States into a more multi-polar world with multiple engines of growth that will eventually benefit everybody.

Insofar, the deceptive nature of the decoupling theory as a guide for market trends came from the fact that this theory did not try to account for short term market movements but rather for long term secular changes that take decades to produce their full effects.

Indeed, "decoupling bears" may have it right when it comes to markets. As emerging economies open up, there capital markets become more connected with the rest of the world, tearing down the concept of decoupling in capital markets. Alongside local investors serving local communities (e.g. pension funds and insurance companies), there will be a growing pool of global investors moving their money where they feel the most valuable opportunities are.

But as more money flows in somewhere, it will drive asset valuations up and make it better to look elsewhere. This is a never ending cyclical reallocation process that contributes to market efficiency and helps finance play its role as a means of efficient economic resource allocation.

However, when it comes to long term economic trends, and except for technological ruptures à la Kondratieff that happen once in every fifty years, it is obvious that the best opportunities are located in economies where the stock of capital is lower, the demographic factors more favorable and the needs more important than in old mature economies. On this account, the future clearly belongs to Asia and Africa.

Once this is understood, the good and bad sides of the story can be reconciled and the "treasure" can be unhidden at the expense of the ugly side that has been brought out of the game.