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.

There’s an apocryphal tale about a nervous investor that’s made its way around Wall Street recently. The investor is nervous, the story goes, not because he sees turmoil in the markets but because he’s optimistic and doesn’t know whether his optimism is justified.

Sound familiar?

The month of May - colored with headlines like “As stocks rise, Wall Street turns optimistic,” and news such as the upward revision of Q1 2008 GDP growth from .6% to .9% - gave new strength to optimism that the worst of the credit crunch is now behind us, along with the expected backlash: what if it’s not?

It is against this backdrop that a newsworthy item published a few days ago by S&P Equity Research received little notice - perhaps dutifully so because these kinds of comparisons are all too common, but this one stood out for its optimistic tone:

“. . . the Standard & Poor’s 500-stock index advanced an average 19% during the 12 times since World War II after the Federal Reserve Board started a rate-cutting program. Indeed, the S&P 500 was higher 12 months after the first rate cut in 11 of the 12 observations, with 2001 being the only time in which the equity market benchmark was not higher a year after the initial cut.

This time around, even though the S&P is down 6.2% through May 16 since the Fed started its rate-cutting program on Sept. 18, 2007, the market was also still in negative territory six months after the first cut in four of the prior 12 observations, so we still have a chance for the “500″ to advance in the next four-and-a-half months.”

[FYI: a complete synopsis of market performance during post-WWII Fed easing cycles can be found here.]

The “glass is half-full” tone of this report may give investors confidence in light of the streak of positive news throughout last month, but I saw it much more as a warning of undue optimism in the market.

In February, looking at just the last four Fed easing cycles (2001, 1998, 1995, 1989), Bear Stearns estimated that, on average, the S&P 500 has gone up 5.7% and 7.6% during the first 6 and 12-month periods since the first rate cut, respectively. This time around, things look remarkably bleaker (see chart below):

Through the six-month period from the first Fed cut in September, the S&P was down a whopping 12.4% and - despite edging higher in the middle of May - now stands at about (8.00)% since the easing cycle started. That means that if the S&P is to break even for the 12-month benchmark since the Fed easing began, it will have to coast about 800 basis points higher in less than four months against the headwind of soaring oil and rising unemployment.

Possible? Sure. Highly unlikely? Definitely.

But the problem isn’t with the equity markets but rather with the economy’s fundamentals - which are the real benchmarks that investors should be paying close attention to. In the age of globalization, multi-national corporations and a weak dollar, U.S. equity indexes such as the S&P 500 just aren’t as good of indicators for the health of the economy as they used to be since it’s hard to tell whether they’re really reflecting domestic or international growth. But domestic unemployment - which recently jumped a steep .5% to 5.5% (up 1% year over year), rising inflation and soaring commodity price indexes continue to tell the real tale, and it should continue to make the optimistic investor plenty nervous about in the coming months.

[FYI: in case you are interested to see how the 10-year treasury yield has fared during the first half of the current Fed easing cycle, PIMCO provides a neat summary of that on their 2007 subprime timeline.]