Emerging market "decoupling" theory may be premature

NEW YORK Fri Oct 12, 2007 4:32pm EDT

A street sign on Wall Street outside the New York Stock Exchange September 18, 2007. The U.S. accounts for about 25 percent of world output and in past business cycles investors have suffered as world stockmarkets have weakened when U.S. economic growth has slowed, as it has this year, or slipped into recession. REUTERS/Brendan McDermid

A street sign on Wall Street outside the New York Stock Exchange September 18, 2007. The U.S. accounts for about 25 percent of world output and in past business cycles investors have suffered as world stockmarkets have weakened when U.S. economic growth has slowed, as it has this year, or slipped into recession.

Credit: Reuters/Brendan McDermid

NEW YORK (Reuters) - The notion that the U.S. is no longer the driver of world economic growth is in vogue on Wall Street, yet the idea that Europe and Asia have "decoupled" from the American economic engine may be more an investor hope than a sound investment theory.

Investors would like to believe that a portfolio which is diversified across both developed and emerging markets would continue to perform well, even during a U.S. recession, because Chinese economic growth is creating insatiable demand for raw materials in particular.

The U.S. accounts for about 25 percent of world output and in past business cycles investors have suffered as world stockmarkets have weakened when U.S. economic growth has slowed, as it has this year, or slipped into recession.

"A lot of my colleagues are arguing that it is different this time around," said Andrew Milligan, head of global strategy at the investment arm of UK insurer Standard Life Plc (SL.L).

Large new sources of demand have emerged in China, India and elsewhere, and may be sufficient to counter the impact of a U.S. recession, argued Milligan, who directs investment strategy at Standard Life Investments which has about $280 billion in assets under management.

In addition, in the event of a U.S. recession, the Chinese government could increase its spending to ensure China's annual economic growth does not slip below its recent average of around 10 percent before the 2008 Beijing Summer Olympics, he said.

World stockmarkets have recovered since a global credit and liquidity crisis in mid-summer, and in some countries stocks have rallied to new highs, partly because of the belief that Chinese economic growth is offsetting the impact of a weak housing sector on the U.S. economy.

CHINA AS WORLD'S DYNAMO

An enormous shift has occurred in the global economy away from the developed world to emerging markets, said Antoine van Agtmael, who is chairman of Emerging Markets Management LLC in Arlington, Virginia, and who is credited with coining the term "emerging markets."

"Whereas the big sucking sound in the past was the U.S., the big sucking sound is now China," van Agtmael said in an interview.

Emerging markets now account for about one-quarter of global gross domestic product, about the same as the U.S. contribution, he noted.

China's economy is expected to grow about 10.5 percent in 2008, close to Wall Street's consensus, and is set to become the No. 1 driver of global growth for the seventh straight year, Merrill Lynch said earlier this week.

Still, van Agtmael, who is attributed with first using the term "emerging markets" as an alternative to "Third World" in the early 1980s when he was a World Bank executive, remains skeptical that the world can fully decouple from the U.S. economy.

"That is nonsense," said van Agtmael, whose firm manages about $20 billion in emerging market equities.

In an age of globalization, emerging markets are part of the world and a U.S. slowdown is likely to be felt globally, he said.

"If there is a slowing in the United States, and especially if there is a slowing not just in the United States but in other parts of the developed world, then yes it will be felt" around the world, said van Agtmael.

BEWARE OF CREDIT CRUNCH

Indeed, investors are missing the point when they examine the global growth story, said Richard Bernstein, chief investment strategist at Merrill Lynch, in a research note this week.

The sectors or asset classes that have outperformed in recent years relate to capital intensive infrastructure development in China and emerging markets which has increased demand for energy and other commodities, said Bernstein.

But this global economic growth is a symptom of easy access to cheap capital and investors would do well to heed the recent and ongoing tightening of credit around the world, he said.

As for the decoupling theory, if anything, emerging markets are more sensitive than ever to volatility in U.S. markets, he said.

As U.S. stocks have rallied to new highs following the Federal Reserve's discount rate cut in August, Chinese stocks have surged also, Bernstein said.

Chinese stocks listed on the Hong Exchange .HSCE have soared by about 85 percent since the Fed's discount rate cut.

"If truly decoupled, why would that happen?" he said in an e-mail response.

Van Agtmael, despite his enthusiasm for emerging markets, concurs.

"I am a bit of a skeptic at the moment because I believe people have overreacted to this as if emerging markets are now a big island that is unconnected to the rest of the world," van Agtmael said. "Are they economic islands? No, they're not."