October 2009

INSIDE VIEW: Decoupling theory - myth or reality?

With emerging markets posting faster growth rates than developed markets, John Pollen, at Pioneer Investments, considers the extent of global dislocation.

paddyfield.jpg In this context, decoupling implies that emerging market economies can maintain a different growth path than developed economies. It is not clear when this notion was first expressed, although it has become widely talked about in the global economic and market boom times from early 2003 to 2007.

The acronym Bric, which refers to the large emerging market economies of Brazil, Russia, India and China, was first coined by Jim O’Neil of Goldman Sachs in 2001. His idea was that due to rapid economic development, the economies of these countries could overtake many of the current largest economies of the West and Japan. This analysis is one of the first or at least most widely known theories on decoupling. It was certainly a catalyst for the concept as a whole to gain traction.

Definitions of decoupling
In its true sense, decoupling means to separate or diverge. On a literal interpretation, decoupling was not really taking place during the boom years 2003-2007. Developed market economies were enjoying strong relative growth compared to their averages, and so were developing economies. However, developing economies were growing a lot faster than developed economies. There are two thoughts here. Are people misusing the word decoupling just to mean faster growth or do they mean that due to the structural changes that are taking place, developing countries can maintain a growth path in the future despite any downturns in developed economies?

The chart above shows a trend that you could call decoupling – namely, while China accumulates foreign reserves, the US is issuing more debt, a good deal of which is owned by China.

The old saying that ‘when America sneezes everyone else catches a cold’ has been broadly true in the post-war years of US economic supremacy. The boom-bust cycles also used to be felt more severely in emerging economies, as many were very reliant on exports to the US. This has certainly changed in the past decade or so since the late 1990s crises in Brazil, Russia and Thailand. Emerging economies are now structurally much healthier and have seen rapid growth in domestic markets, thus lessening their reliance on exports to the US and other developed markets. However, despite huge improvements, the world economy is now more interlinked than ever, and pain in one large area will still be felt elsewhere.

What has changed is the scale of the impact that downturns in developed nations can inflict on the developing world. Taken as a whole, developing countries are a lot more resilient to exogenous shocks than in previous cycles, although, as with developed nations, there are still large differences within the universe. For instance, while Brazil and Russia have experienced severe falls in output, economic growth has fallen in China and India but is still positive and much higher than in most other countries.

A view on the markets
From a market perspective, emerging market equities initially held up well relative to past experiences in the unfolding of the credit crunch. For instance, they outperformed in the first half of 2008. It was in the second half of 2008 that emerging equities underperformed. This was when analysts started saying that it was the end of the decoupling phase that had seen emerging equities outperform developed markets since 2001.

Developing markets have outperformed over the past 20 years and this period showed two distinct trends. The first decade or so showed what used to be the norm: a strong period of outperformance followed by a strong period of underperformance. The second, more recent, phase just showed strong outperformance, as long as you believe that a short, sharp V-shape in mid to late 2008 was just a temporary blip. Indeed, analysis shows it is now back on the same trajectory as it has been for most of the period, thus highlighting that the trend has been maintained.

The recent period of underperformance for emerging equities was relatively short: underperformance started in early July 2008. However, since bottoming out in this down cycle on 27 October 2008, emerging market equities have significantly outperformed developed markets: 87.7% compared to 27.6% to 14 August (in US$ terms). Developed markets carried on falling for many months after developing markets and only bottomed out on 9 March 2009. Even since then, emerging markets have still outperformed (75.7% vs. 54.5% to 14 August).

In conclusion, both from an economic and market perspective there will never be a total dislocation between markets globally, as the same trends and forces are in play, albeit to different degrees. In addition, decoupling in the sense that developed markets will fall and emerging will go up is not true and never has been. However, decoupling in the sense that emerging economies and markets can grow faster than developed markets, helped by rapid domestic growth and intra-emerging market trade, is certainly true and likely to be so for a considerable period.

• John Pollen is head of emerging markets at Pioneer Investments.

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