The truth about emerging market 'decoupling'

I should begin 2012 by wishing you a happy new year even though this will mark the fifth year of the global financial crisis and all its repercussions are still with us.

Fortunately there are some reasons to be cheerful. Economically, many emerging markets continue to transform at a spectacular pace, despite the sluggishness of the developed world. Unfortunately that hasn't been reflected in our investments recently.

So this week, I want to revisit that much reviled term "decoupling". We'll see how in one sense, emerging markets seem to have decoupled from the developed world - but how in another crucial respect, the break has yet to be made.

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Defining decoupling

The simplest way to think about decoupling is one economy growing completely independently of another. So if developed economies are growing at say 3% per year and emerging markets at 6% per year and the developed economies fall into recession, emerging markets continue growing at 6%.

Given how interconnected the global economy is, that seems pretty unlikely. If one group of countries hit trouble, everybody is likely to feel it. The only way this would happen is if the two groups don't really trade with each other at all - and that's obviously not the case for almost all economies today.

And of course, 2008 bore this out only too well. The US and Europe went into recession and the developing world certainly didn't carry on regardless. Any idea that emerging economies could fully decouple from what was going on elsewhere was obviously very wrong.

The surprising strength of emerging economies

But that's not the whole story. For a different perspective, compare the average growth rate for the developed and emerging worlds over the last decade, as in the chart below.

Emerging v developed markets - real GDP growth

You'll see that the emerging economies were growingthree to fourpercentage points faster than developed ones before the crisis, maintained about the same gap during the crisis and have continued to do so in the short time since. So in another sense, they did decouple. They still maintained the growth gap at about the same size throughout.

That's significant, because emerging economies are often seen as being entirely geared to growth in the developed world. When the US and Europe are doing well, emerging markets do even better. When they falter, emerging markets fall harder.

That's certainly true of some emerging economies. If you're a small, trade-dependent economy, you will outperform to the upside and to the downside. But it didn't hold true for the emerging world as a whole. Large, more domestically driven economies such as China, India, Indonesia and (to a lesser extent) the Philippines held up much better.

There is a substantial bloc of economies within the emerging world that have their own momentum and aren't solely dependent on what happens in the developed world, even though they are still affected by it. A decade or so ago, this wasn't so true; the emerging economies that investors cared about then were mostly smaller and more export-centred.

No decoupling in stocks

The third decoupling question is what happens to stocks and other investments. Here, the story was clear enough - there was no decoupling.

As all investors will know, emerging market stocks underperformed developed ones dramatically in 2008 and again more recently, as the chart below shows. (The orange line is the MSCI Emerging Markets Index, the green line is the S&P500.)

The fact that emerging market economies overall continued to deliver better growth had absolutely no effect on their stock markets. Nor did the fact that earnings growth for emerging market companies also beat their developed peers - by a margin of 10-15 percentage points (depending how you measure it) cumulatively over 2010 and 2011, according to UBS.

The problem is that Wall Street still has the rest of the world on a leash. What happens to emerging markets stocks is to a large extent determined by investment flows from the US and other developed countries. And in times of trouble, these overseas investors decide to reduce risk and sell emerging market stocks.

Good economies, bad investments

That raises a question that troubles me a great deal. Is it possible that emerging markets could continue to outperform developed ones in years, yet not see that reflected in how their stock markets perform?

The first part of that scenario seems pretty likely. Emerging markets generally continue to look in better shape than the developed world. They have lower debt. They have better demographics. They have stronger consumer demand: if you look at domestic consumption growth, the difference between the emerging world and the developed world is even greater than with overall GDP.

Emerging v developed markets - consumption

Yet all this was true last year. And you'd still have been better off in US government bonds than emerging market equities or almost anything else last year.

Could US bonds be the star investment?

The yield on the ten year Treasury is down to 2% and it might seem unlikely they could fall further - but we've long said the same about Japanese bonds, and ten year Japanese government bond (JGB) yields are now under 1%. So it's a very real question whether US bonds, not emerging markets, could turn out to be the investment story of the next decade, with yields grinding steadily lower along the same path as Japan.

This is certainly not a possibility that can be dismissed out of hand. However much we may dislike the idea, lending to profligate and incompetent governments at 2% per year could prove more rewarding than investing in the development of the majority of the world!

That said, I don't think that this is the way that things will play out in the medium term, for a couple of reasons.

On the emerging markets side, while emerging market stocks fall further when times are bad, they rise even more strongly when times are good, tending to put them ahead over time. (On the chart above, notice that even after the recent sell-off, the emerging markets index is still ahead on a five year view.)

When fear fades, foreign investors come back, often kicking themselves for selling at the wrong moment. Exactly when the fear around the eurozone disaster will quieten down is anyone's guess, but eventually it will and the appetite for risk will return.

And the longer developed-world economies remain sluggish, the more attractive that emerging market growth premium will look. The experience of Japan may be telling on this point.

JGB yields went ever lower, at least in part because Japanese banks - both unwilling to lend and unable to find enough potential borrowers - increased the percentage of their assets they held in safe government bonds. As for Japanese stocks - well, we all know what they've been doing for the past two decades.

But at the same time, Japanese investors became ever keener on investing overseas in the hope of getting a reasonable return. Japanese retail investors hold sizeable proportions of many foreign stock and bond markets, including emerging Asia.

It seems plausible that we could see the same outcome in the West. US, UK and some European government bond yields remain artificially low as weak bank balance sheets and borrowers' desire to pay down debts leads banks to increase their bond holdings drastically. At the same time, investors looking for for slightly more than a safe 2% per year increasingly turn to emerging markets.

Where this would leave developed world stocks is another matter. In their favour, they are nothing like as overvalued as the Topix was in 1990. But the S&P500 in particular is not cheap; long-term measures such as equity q and the cyclically adjusted price/earnings ratio suggest it may be 40-50% overvalued, although there are reasons to think that this exaggerates the problem.

And many good quality multinationals look relatively decent value. Companies such as this that can profit from opportunities in the rest of the world may still do well, while more domestically focused poor quality stocks suffer. Not every stock in Japan went down between 1990 and now.

All this said, I struggle to see US, UK and German government bonds repeating what Japanese ones have done over many years. There are substantial differences between Japan then and most developed countries now.

For example, there is far less societal willingness to tolerate deflation, meaning that central banks are likely to pursue much more aggressively inflationary policies if they think it necessary. Hence while low yielding JGBs were still able to deliver real returns, low yields elsewhere are unlikely to do so.

So overall, while there will be plenty of ups and downs, emerging market equities seem likely to be the long-term outperformers that their economies' superior performance would suggest. Unfortunately, that turnaround is unlikely to happen tomorrow.

Hopefully, the euro crisis will come to a head in 2012 and developed-world investors will flee into safer assets. And with emerging market central banks likely to begin loosening monetary policy last this year, domestic sentiment should also start improving as the year goes on. But for now, the most noticeable decoupling may be one we don't want - that between emerging economies and their stock markets.