Cezary Salad

For anyone interested in emerging markets, the mot juste all of last year was the d-word: “decoupling”. In a nutshell, it’s the theory that emerging economies have gained enough critical mass to chart their own path to growth and prosperity independently of the developed economies in Europe and North America. In other words, a recession here shouldn’t automatically translate to a recession there.

In 2008, the concept became so controversial among economists that one could even catch the venerable Economist weighing-in on both sides of the debate (“Decoupling is not a myth” – March 6, 2008 print edition; “So much for decoupling” – 18 September, 2008 print edition).

This week, Newsweek’s international editor, Fareed Zakaria joined the fray. Zakaria, an astute observer of foreign affairs, argued in his June 8 Newsweek column (“Boom Times Are Back - Just not here in the United States”) that the global economy is increasingly going to become a tale of two worlds. In one camp, there will be the booming, hard-charging emerging economies like China, Indonesia, India and Brazil and in the other the lagging bastions of wealth and power like the US, Europe and Japan (unless, of course, the latter undertake drastic reforms to alter this inevitable fate).

For regular followers of Zakaria, this, of course, is nothing new; his bestseller, The Post American World, is an exposition on this very same paradigm. And he made the same point last year in an article for his previous employer, Foreign Affairs magazine.

But one paragraph caught my attention since, without naming the controversial d-word, Zakaria seemed to use it as a way to justify the tale of two worlds:

Over the past six months, much conventional wisdom about the economy has been discredited. The old experts who spoke with confidence about unending global growth—the boomsters—have been debunked. But the new pundits of pessimism—the doomsters—have demonstrated a similar hubris, ignoring any evidence that might complicate their story. Six months ago, stock markets around the world swooned in unison as the American financial system seemed on the verge of collapse. This led many to conclude that the emerging economies of Asia and Latin America had been growing only because of their exports to America and Europe; that they obviously had no independent strengths of their own and would in all likelihood collapse faster and more furiously than the sophisticated economies of the West. After all, these were Third World countries.

Not exactly. Zakaria’s got the big picture right – there is indeed a growing rift between these two worlds – but he oversimplifies the details of how this fits in vis-à-vis decoupling.

First, one ought to take a longer reference point than the last six months. After the credit markets exploded in August 2007, emerging markets were one of the first places investors went with their displaced capital. So then, like now, as markets peaked here in the US and in Europe, they continued to hum along in places like Brazil, Russia and China.

Then, of course, came the big crash in January 2008, when markets tumbled all around the world and the Federal Reserve made its emergency 75 basis point cut to stem a similar panic here in the US before markets opened on Tuesday, January 22, 2008. It’s that episode, much more than the post-Lehman collapse roller-coaster, that’s ground zero for any debunking. We saw then these “new pundits of pessimism” argue that the emerging economies would follow the US into recession and the “old experts” appeared debunked. Now, thanks to the recent bull market, it seems the opposite is true.

This, of course, sits well with Zakaria’s tale of two worlds. He cites China’s Shanghai index (up 45 percent this year), India’s Sensex (44 percent), Brazil’s Bovespa (38 percent) and Indonesia’s index (up 32 percent) as evidence of this debunking.

But it is more helpful instead to look at peaks and troughs. US markets (as measured by the S&P 500 Index), peaked in October 2007 and bottomed in March 2009. Stocks are a leading indicator, so this means that investors thought the US would enter recession around 1Q 08 and re-emerge sometime this year.

China’s Shanghai index likewise peaked in October 2007, but it troughed earlier – November 2007. India’s Sensex peaked in January 2008 and troughed in March 2009. Brazil’s Bovespa fared better, peaking in May 2008 and troughed in October 2008 (see chart below – interactive version is available here. Indexes are rebased to August 2007 and presented on a logarithmic scale; I left Indonesia out since I don’t know which index Zakaria was referring to in Jakarta).

What’s remarkable about this portrait is that all of these economies seem to have followed the US into recessionary bear markets, peaking after the S&P and recovering before or as it recovered. This begs the question: did these and other emerging countries begin to recover because of their own, innate strength or because investors saw recovery on the horizon in the US and other developing markets?

I certainly don’t claim to have an answer to this question and, as Zakaria wisely points out, stock markets don’t tell the whole story. But it just goes to show that this whole debate is a lot deeper and more complicated than he makes it out to be in his column.

In the long run, though, he certainly has a point: China, Brazil, Indonesia and other emerging economies are certainly in a better fiscal shape than the US and Europe right now and are poised to grab a larger share of the world’s wealth and power in the coming decades.

But how they get there and who follows who is far less clear than the black-and-white tale of two worlds.

Yesterday most major U.S. stock indexes finished the day either flat or slightly lower as markets await with anticipation to see what action the Fed will take at the end of its two-day policymaking meeting that starts today.

It’s a sort of nervous quiet-before-the-storm that comes whenever the markets anticipate a change in direction in Fed policymaking. But this is not just a drizzle; investors are curious to learn how what the Fed’s next step will be in tackling what seems to be the perfect storm of sky-rocketing commodities costs, soaring inflation and a plummeting dollar.

After nine months and 325 basis points of easing, fed funds futures are overwhelmingly pointing to a halt in easing - to be exact, an 87% probability (as of June 20th) that the FOMC will leave the Federal Funds Rate target unchanged, as calculated by the Cleveland Fed.

This comes as no surprise since most economic indicators still point to an uncomfortable netherworld between contraction and expansion that seems to call for a pause and rethink of where the economy is going. The index of Leading Economic Indicators (LEI) - a composite of a group of 10 macroeconomic statistics that are known to change in advance of a contraction or expansion - despite moving higher by a slight .1% last month, gave us little insight since six of the ten components moved down and October through February marked a period of -1.8% contraction in the LEI that fell just shy of predicting a recession (according to the rule of thumb of 2% decline in the index over six months and a majority of components moving lower).

No matter what it decides to do, the Fed will likely highlight this uncomfortable netherworld situation in its statement on Wednesday, warning us of the continuing downside risk and the need to monitor the inflation situation closely.

Important as this may be, though, the real words to watch for in its statement - given recent statements by Treasury Secretary Paulson and Fed Chair Ben Bernanke - will be the dollar and commodities, both of which have been enjoying increasing popularity on Capitol Hill and the campaign trail lately, and for obvious reasons.

Since Mr. Bernanke has taken over as the chairman of the Fed, the dollar has depreciated in value against most of the world’s major currencies (this clever graphic from the Telegraph says it all) - a decline that has only thrown more fuel on flame-hot commodity prices, which have become increasingly correlated with the depreciating dollar over the last year. This should come as no surprise: after all, with credit markets frozen and falling interest rates at home, where were investors to park their money except foreign currencies and a booming commodities market?

Still, as anyone who regularly reads the FOMC’s carefully-crafted and blandly worded policy statements knows, the Fed is unlikely to make a big splash about commodities and the dollar. Nonetheless, investors are curious to know whether all the talk of bolstering the dollar and reigning-in commodities prices really has any policy teeth behind it - which is why the reason behind the Fed’s staying the course, if it does so, will be particularly illuminating.

If it cites the threat of inflation as its primary policymaking motivation, then the case could be made for a prolonged wait-and-see approach since inflation is a lagging economic indicator. On the other hand, if it cites worries about the plummeting dollar and its impact on soaring commodities prices, then there is a strong argument to be made that there is little time to waste since both are already at historic lows and highs, respectively. As a result, the Fed will be expected to raise rates sooner rather than later, (in which case expect to see the implied probability of a 25 bps increase in August edge higher than the current ~20%).

But whether it’s soaring commodity prices, inflation, or a plummeting dollar, at the root of each - as well as their after-shocks in the over-heated housing markets - lies the 2001-2004 Fed easing cycle carried too far and too long. This is why some economists, including Dr. Benn Steil, Director of the International Economics Council on Foreign Relations, have wisely begun to point out that we are currently experiencing not so much the beginning of (yet!) another bubble, this time in commodities, but rather the aftermath of a previous, much larger currency bubble. As Steil testified two weeks ago in front of the Senate Committee on Homeland Security and Governmental Affairs, “the Federal Reserve pushed rates too low and held them too low for too long, and has since last autumn been exceptionally aggressive in driving them well below the rate of inflation.”

The “since last autumn” part is, of course, how we got to this spot in the first place, and doing so again will only continue to widen the yield gap between the United States and the rest of the world, including oil-rich states like Saudi Arabia, which last year for the first time refused to lower its interest rates in lock-step with the U.S. Federal Reserve.

A telling sign of the times? Certainly; but more so a reminder not to repeat the mistakes of the past - even in the face of the perfect storm.