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.

Are we in a recession?

Today, the National Bureau of Economic Research (NBER) - the official research group tasked with dating when a recession begins and ends - will get its first hint of whether the U.S. is in a recession. That’s because at 8:30am, the Bureau of Economic Analysis will publish its first-draft figures for chain-weighted U.S. GDP growth for the first quarter of 2008. Given all the speculation that we have heard in the financial press about whether or not the country is about to enter into, or is already in, a recession, this will definitely be the figure to watch, so don’t miss it. What will it look like? To be sure, the actual chain-weighted GDP release over the past few quarters has looked nothing if not volatile (see below).

However, here are some hints of what the market is expecting:

• The consensus estimate for 1Q08 annualized GDP growth published by the IDEA group, a market intelligence provider, is an anemic but above-negative .3%
• As of yesterday afternoon, Bloomberg placed the average of 80 economist estimates at .4%, with a distribution slightly skewed toward higher growth (.5% median, -.8% low, 1.5% max)

Digging a little deeper, 2007 has thus far posted negative growth in three sectors: construction (-12.1%) and finance/insurance (-.3%), which were a related phenomenon due to the subprime bubble, and nondurable goods (-1.1%).

The question is thus whether the strong contraction in the housing market and the financial services sector continued into the first quarter of 2008 without being sufficiently offset by stronger growth in other sectors to prevent the overall economy from dipping into negative growth.

As you can tell from the consensus estimates, most economists don’t seem to think so. We’ll know for sure in the next few hours, so get ready for an exciting day on Wall Street because if the GDP does indeed stay out of the red then this will be a day to remember.

Ahead of next week’s Federal Reserve on meeting on Tuesday and Wednesday, markets seem convinced that another 25 basis point reduction in the fed funds rate is likely. But whether it’s necessary is whole different matter.

Since the Fed embarked on its latest easing cycle in September of last year, it has cut the fed funds rate from 5.25% to 2.25% - ostensibly to defend against further deterioration in the economy due to the fallout from the credit crunch. But now, as the risk of higher inflation becomes more and more pronounced, there is reason to question whether a seventh cut in eight months would make much difference.

The first argument in favor of a pause in the easing cycle rests squarely with inflation. The recent inflation data from the Bureau of Labor statistics (plotted below on a year-over-year basis) has not been encouraging. Year-over-year inflation in the U.S. is now hovering around 4% - about twice the comfort level for most investors. Netting out food and energy costs (the red trendline), it’s clear that it is the commodities boom and concern about food prices that’s adding on the extra 1.5-2.0% to the inflation rate (see below). And considering that food and energy collectively hold a 25% weight in the CPI, what we’re seeing is one-fourth of the index driving about half of its year-over-year growth. But that has an impact on the rest of the index as well since consumers can’t very easily cut down on food and energy spending, meaning that everything else effectively occupies a higher percentage of their income post-food and energy. Point being: regardless of the gap between universal (blue) and core (red) CPI, inflation has been gaining strength in the economy, and is likely to do so unless some part of the equation changes.

(Note: if you’d like to play around with the inflation rate and come to your own conclusions, I can recommend no better source than the Federal Reserve Bank of Cleveland’s U.S. inflation page).

One potent part of the equation is, of course, the level of interest rates since more money in the economy made available by cheaper cost of capital means more inflation. Now, banks’ unwillingness to lend in the wake of the collapse of the credit markets last year, a lowering of interest rates was in many ways a necessary and appropriate policy step on the part of the Fed. But keep in mind that there is usually a 9-18 month lag from the moment that there is a shift in fed policy to when the real economy starts to respond. So, the argument goes, why not wait and see whether the medicine (combined with all the other credit crunch solutions the fed has rolled out) is working before you apply more of it, especially if it means risking stoking the fires of inflation which we already see lighting up.

The counter-argument is, of course, that we’re currently staring into the abyss of a recession - if we’re not already in one - and so it would be wise to have additional insurance against the downside risk of a recession, even if it means risking higher inflation in the short term. If credit conditions continue to worsen and consumer confidence weakens, spending and investment could continue to decline, leading to higher unemployment and an even-worse recession scenario (for a fantastic summary of this whole issue, see Greg Ip of the Wall Street Journal discuss his article on this subject in the video below). That leaves the fed in the difficult spot of having to choose between the potential for higher inflation or higher unemployment - the classic dilemma of fed policymaking.

So what’s the tiebreaker?

Legitimate concerns about inflation and unemployment aside, it is time that we start to consider another, less orthodox argument in favor of raising interest rates: the fed funds rate just isn’t the center of attention that it used to be. In today’s globalized economy, interest rates abroad and the actions of foreign investors have a much stronger impact on the strength of our economy than they used to. One potent example of this is the prevalent use of the London interbank offered rate, or Libor) as a benchmark interest rate in much of U.S. lending and - just as importantly - credit default swaps (CDS), which have become an increasingly popular financial instrument for managing and transferring the risk of default to someone more willing to accept it - obviously, for a price. I recently asked a friend of mine who deals credit default swaps what the first indicator he looks at in the morning is, expecting him to say something along the lines of the 10-year treasury or some other U.S. interest rate benchmark. Not so: it’s the spread between Libor and U.S. interest rates - just another example of how important this rate has become.

But the spread between U.S. interest rates and foreign rates is particularly important in an easing cycle because if trillions of U.S. corporate debt and mortgage loans are tied to a foreign rate on dollars like Libor, and foreign rates are higher, then lowering our interest rates simply doesn’t make as much of a difference as we would like it to. A clear indication of this is the fact that the average rates submitted by U.S. banks vs. European banks to calculate the Libor formula have consistently been lower since about the middle of the month, as reported by the Wall Street Journal this week. As a result, some are calling for the creation of a “NYbor,” or a Libor formula that reflects the borrowing costs of U.S. banks only, since it’s clear that U.S. borrowers are currently paying higher rates that exist on the other side of the pond.

Hence, it’s right to ask whether lowering the fed funds rate target is likely to make that much of a difference in this interconnected global environment, especially since interest rates at most other major central banks currently set higher (see table below or complete world interest rate data here). That spells further devaluation of the dollar against the Euro, the Pound and currencies of other major world economies if we continue to cut our interest rates relative to theirs. Sure, that may aid exports, but it is also likely to add even more inflationary pressure to the economy due to higher costs from imports.

Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan, comes to the same conclusion using a different argument. In a recent editorial in the Wall Street Journal, “Enough With the Interest Rate Cuts.” Feldstein argues that cutting the interest rate won’t make as much of a difference as we’d like it to in stimulating our economy since “in previous recessions, lower rates stimulated aggregate demand by inducing increased home building. But with the massive inventory of unsold homes – up 50% from a few years ago – a further cut in the fed funds rate would have little effect on housing construction.”

So whether you look at it from the domestic standpoint or more globally, a cut in the fed funds rate at this point doesn’t carry as much upside as it does potential risks. Small surprise, then, that ahead of next week’s fed meeting, there isn’t as much excitement about the prospect of a rate cut as there is nervousness. Perhaps giving interest rate cuts a breather, then, is not such a bad idea.