Emerging markets 'decoupling' theory is back, but it's still wrong

The 'decoupling' theory - that emerging markets could shrug off a downturn in the industrialised world - was proved wrong as the downturn went global. Now it's back in fashion. But that doesn't make it right.

Remember decoupling? The theory, which was fashionable two years ago, held that emerging economies and markets, notably Asia, could shrug off a downturn in the industrialised world.

But as global growth and equities slumped last year, emerging economies tanked, and the MSCI Emerging Markets index fell by 53% from its peak. Yet now decoupling is back in fashion.

The FTSE Emerging Markets index has gained 72% since it bottomed in October, outperforming the developed markets index (which only bottomed in March) by almost 50%. This year alone Russia and India have gained 70% and 62% in dollar terms, while the MSCI Asia ex-Japan index is up by 34%. Money is pouring into emerging markets, says John Authers in the FT, in the hope that developing countries, especially China, "will pull the world through".

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Asia is still struggling

But can they? Of the major emerging markets, Brazil and Russia look set to shrink this year, while on the Asian front even in China "the trajectory of recovery will be less dramatic than those V-shaped projections suggest", says Lex in the FT. Government stimulus has ensured a sharp rebound in loan growth and has stimulated investment and manufacturing, which is growing again. On the other hand, waning electricity consumption and softening steel production point to weak demand at home and abroad, and exports remain weak, dropping 23% year-on-year in April. Across Asia, April's data may have been encouraging, but last month, for instance, Korean exports fell by more than in April.

and it can't lead the world anyway

So the picture in Asia and China is hardly unequivocally positive. Even if it were, there's a hitch, says Stephen Roach of Morgan Stanley in Time: "Asia remains an export machine", with demand for its goods underpinned by industrialised world consumers, especially America's.

The share of GDP comprised by exports across Asia hit a record 47% in 2007, while the importance of consumption has declined. And now "overly indebted, savings-short" US consumers, the world's biggest spenders, are "tapped out".

With their wealth plummeting as house prices decline, and unemployment rising, their spending is likely to be subdued for years. Export-led China is unlikely to get a "kick" from the US consumer, raising the spectre of a "relapse" for China-led Asia. "Asian-led global healing remains a real stretch." The shrinking developed economies still account for almost 75% of the global economy, says Alexandre Kateb on Seekingalpha.com. China still depends on the rest of the world.

The rally looks vulnerable

On top of that, emerging market valuations "are no longer attractive", according to Morgan Stanley. In Asia ex-Japan, the price-to-book value ratio has jumped to 1.8, the 30-year average. Yet these are hardly "average times", given that the data is still deteriorating, says Citigroup.

Meanwhile, earnings forecasts suggest that this regional profit downturn will have been the second-shallowest on record. The emerging markets rally looks "overdone", says Thomas Gerhardt, manager of the DWS Bric fund. In short, the emerging market sector is a "geared play on the developed world", as Nigel Rendell of RBC Capital markets puts it. With the V-shaped recovery investors are hoping for unlikely to occur, emerging market investors face a rocky ride.