Debunking the Decoupling Theory

The last week has seen contagious and discontinuous market swoons rile global investors, policy makers and pundits. The Hang Seng and Shanghai gyrations have been stomach turning. European and Asian markets have delinked, relinked, delinked and tumbled. The only consistent trend is down, down, down.

Multiple theories have been fed through the meat grinder with the allocations they inspired. Trillions of yuan, US dollars, yen and euros in paper wealth have been transformed into fuel for a fear inferno. Of course this will not last forever. Time will salve wounds, and leading firms and prudent long-term plays will eventually emerge. Our first order of business must be to understand what is actually happening. The first casualty of fear is perspective. Let’s try to zoom out, take in the action and figure out what is going on.

For the past three years, non-U.S. equity market’s returns have handily outperformed U.S. returns. This is compounded by the prolonged slide in the dollar. Since U.S. financial trouble began to dramatically unfold in the summer of 2007, many developing markets continued to trend higher. China has been a leader of this charge. The growth in Brazil, India, China and Russia - or BRIC - has been spectacular over the past few years. As a U.S.-led global slowdown loomed, these traditionally delicate emerging markets continued to outperform.

If we use broad ETFs as proxies for emerging-market performance, we see clearly that these markets have been doing better than the U.S. - even before adjustment is made for increases in their currencies against the U.S. dollar. The 10% increase in value of the yuan against the dollar and the performances of the Hang Seng Index and Shanghai Composite Index are dramatic.

The ETF funds of Latin America, Asia ex-Japan and emerging Europe have all outstripped the U.S. benchmark S&P 500.

Part and parcel of this outperformance has been belief that these economies are poised for rising international import and new era growth. IMF data make clear that in 2007, India and China accounted for more global growth than the U.S..

I don’t doubt that the future global economy will be far less U.S.-centric. I don’t doubt that GDP growth will be more rapid in the emerging markets over many of the coming years. I do doubt they can magically delink from trouble in the U.S. and Western Europe. The U.S., Western Europe and Japan still account for over 50% of world GDP and over 70% global market capitalization.

Part of the carnage of this week has been the realization that delinking theories are delinked from history, economic analysis and common sense.

At the same time as this decoupling fantasy was hit, further fallout from U.S. financial and debt loss overhang became clear. This week we have also begun to see the first announcements of losses from Chinese banks. The Bank of China, Industrial and Commercial Bank of China and China Construction Bank are all believed to have losses from asset links to U.S. mortgages. The US$7.9 billion being discussed now is clearly an early conservative estimate of value at risk.

The slide toward recession in America gained momentum as Treasury Secretary Henry Paulson and President George W Bush pushed fiscal policy stimulus and further weak corporate earnings were announced. Growth slowdowns call into question high energy prices, commodity price highs and asset bottom-feeding. We are clearly not done with credit-related problems and attendant economic weakness. This added fuel to fear’s fire and quickly spread.

Fears of further losses from credit market turmoil and asset write downs riled Asia, South America, Europe and beyond. Lower euro-zone growth estimates and downside risk awareness in Europe’s markets led to volume asset sales. This further spooked Asian investors as Europe has become an even larger trade partner with China than the U.S. Investors have been selling in Asia, Europe and the U.S. at different rates for different but related reasons for the last week.

World central banks - save for the U.S. Federal Reserve - have not responded for fear of stoking inflationary pressures and being seen as narrowly subservient to financial markets. Thus, there has been a delinking of coordinated central bank liquidity policy as global markets melt down. The loss of concerted action by central bankers has added more fuel to the fires.

Asset prices are burning down. Price movements have been bizarre since Friday January 18. Normal correlations and lock step movements in global markets have come unglued. Asian shares trade differently in NY and Hong Kong. European shares trade differently in Asia, New York and Europe. The divergence of course means that market openings are expected to price heavy action elsewhere and influence tomorrow’s action simultaneously.

The first sign of calming will be movement toward harmony across markets’ direction and magnitude of change. I will be scanning the smoky horizon for coupling of market movement.