The Great Decoupling

As Nouriel Roubini pointed out (and Morgan Stanley reminded in its last report), the Great Decoupling thesis has gained some ground amongst The Believers.

Ehmm, the great what? In essence, the idea of the Great Decoupling is that emerging economies (in this case, Latam) are less vulnerable to a US slowdown. Why?

• Because now the region is more dependent on China than on the US.
• Because the region’s macro health is more stable, so foreign shocks are less likely to affect it.
  • “… low fiscal deficits, primary surpluses, falling public and external debt ratios, independent central banks, low inflation rates, flexible exchange rates, move to current account surpluses, large accumulation of forex reserves, less balance sheet vulnerabilities (maturity, currency and capital structure mismatches), corporate and financial/banking reforms, less liability dollarization, moderate policy makers committed to market oriented reforms.” (taken from Roubini’s blog)

Although many of those reasons are true, I think the market may be overestimating the degree of the decoupling.

First, to maintain low deficits and a solid BoP, emerging countries need to maintain fairly positive terms of trade. No one thinks they will return to pre-2002 levels, but just a small reversal could trigger trouble: think about the governments that have “pegged” their fiscal needs to their increased tax revenue. So, if the terms of trade worsen, the main strengths of emerging economies may disappear when needed the most – in a crisis.

Also, China depends on the US. Even if we are decoupled from the US, we are coupled to China, which in turn is coupled with… guess who?

But the largest reason to worry about the decoupling thesis has to do with a (possible) overreaction in the markets.

As the dollar and US markets have performed badly, investors have turned to emerging economies, which so far have stood their ground. So far, so good. Since emerging economies are not perfectly correlated with the US/SP500, investors can gain from diversification.

However, correlations are higher that what recent events may suggest. When investors rush to emerging economies, at a time where the US stocks are falling (or at best, underperforming), the influx of capital increases the returns of emerging markets, thus appearing to show that “when the US performs badly, emerging markets perform well”.

But those increasing returns are caused by more buyers in the markets, not by better fundamentals. And the risk is that the more people see a low correlation, the more they invest in emerging markets, and the more they lower the apparent correlation (if the US markets fall at the same time). In the end, misalignments result, with their expected consequences. But that’s for another post.

PS: For the record, I don’t expect a bubble. Not yet. Smart investors are fully aware that emerging economies are still coupled, so my bet is that we won’t see a rush of money to emerging markets.