Decoupling Recoupling Debate As A Religion

``The highest intellects, like the tops of mountains, are the first to catch and to reflect the dawn.” - Thomas Babington Macaulay (1800-1859), British Poet, historian and Whig politician

If we accept the US-OECD-Asia-Emerging Market sequencing of the global slowdown as proposed by the doomsayers, then by the chain of logic, the US should recover first as the slowdown spreads to the world.

But this is unlikely to be the case since, aside from a busted financial-real estate sector, NET exports have been a key factor to the apparent resilience of the US economy. This implies that a slowing world economy would further account for a drag to the US which is likely NOT to assume the leadership in the coming recovery.

This is where we part from the doomsayers whom have made the decoupling-recoupling debate as a religion or as some form of abstractionism similar to “If you are not with me then you are against me.” Such rigidity makes us unconvinced.

Merrill Lynch’s Richard Bernstein (HT: Craig McCarty) notes that “only 32% of the world’s equity markets are outperforming the S&P 500 so far this year (in local currency). With that performance backdrop, an appreciating dollar could attract “momentum” capital to the US.”

In such a case where then is the recoupling? With 1/3 of the equity markets outperforming the US, how can we say the world financial markets will suffer a meltdown from a deep recession unless we factor in the OECD economies as representative of the whole?

Think of it another way, if oil and food prices will remain depressed over the interim wouldn’t we be seeing some reprieve to the headline inflation pressures of non-commodity export emerging market economies from which they may be allowed room for a recovery and possibly see a reacceleration of economic growth?

Besides, if Mr. Bernstein is right and a strong dollar could push up the US markets based on momentum or M&A (which is in my view signs of rotating inflation), will not the other tightly correlated benchmarks with that of the US also reflect a similar fate?

Commodity Prices Reflect Fundamentals Aside From Monetary Factors

Another, we find it puzzling how the logic of “commodities-will-decouple-but-emerging markets-won’t” will prevail. The cornerstone of such theme is US dollar-paper money oriented.

True, we agree that the US dollar has been an important variable in shaping oil or commodities prices. But again, the world doesn’t seem to operate in simple cause and effect clauses, see figure 2.

Figure 2: CFTC.com: Oil prices Also Reflect Fundamentals

Recently soaring oil prices got the goat of some US public officials who attributed this phenomenon to “speculative” forces. Since the politicians always react on popular issues, they threatened to slap restrictions on the capital markets in order to curb so-called “speculative forces”. Thus, the US Commodity Futures Trading Commission (CFTC) came up with an investigative report to validate or debunk such suspicions.

From the CFTC report, ``The key driver of oil demand has been robust global economic growth, particularly in emerging market economies….world gross domestic product (GDP) growth (with countries weighted by oil consumption shares) has averaged close to 5 percent per year since 2004, marking the strongest performance in two decades.”

In other words, the price dynamics reflected the imbalances derived from variance in the pace of world economic growth against global oil production output more from than speculative activities. Oil production simply couldn’t keep up with global economic growth especially from emerging economies.

In the recent downturn in oil and commodity prices we see the same phenomenon at work, see figure 3 from BCA Research.

Figure 3: BCA Research: U.S. Manufacturing: Global Weakness Adds To Domestic Drag

This from BCA Research, the reputable independent research outfit (highlight mine), ``Global leading economic indicators have rolled over, implying that slower overseas growth will diminish one of the key sources of support for U.S. manufacturers. The July ISM manufacturing survey reported a drop in export orders (albeit the index is still well above its boom/bust line). A slowdown in exports is worrisome because this sector had been the primary source of growth for manufacturers in the past year, as the domestic economy is mired in recession. The only silver lining is that energy prices have finally begun to recede. Although oil prices will have to move substantially lower before having a significant economic impact, energy price relief will help to ease pressure on profit margins and lower inflation expectations. Bottom line: The overall manufacturing sector will continue to grow at a sub-par pace, and the risks will stay on the downside until the consumer retrenchment is further advanced and/or much more relief from commodity prices arrives.”

BCA’s view buttresses our position on the slowing economic world growth and the sensitivity of the US economy to the global conditions.

So as we mentioned above, the US-OECD-Asia-Emerging Market sequencing on the recent economic downshift could be the case today, but from a recovery perspective the market leadership will unlikely come from the same order.

The Acceleration Phenomenon: A Key Emerging Market Dynamic

Now take a look at this commentary from Bloomberg (highlight mine),

``In the past, when the U.S. economy weakened, the rest of the world usually followed quickly, and inflation eased as demand for oil and other commodities fell. U.S. recessions in 1990-1991 and 2001 brought global growth down by half, sending fuel prices tumbling.

``That didn't happen this time. The world expansion barely slowed last year and oil prices surged, even as the U.S. economy shrank in the fourth quarter. Only now -- two years after the U.S. housing boom went bust -- is the slowdown spreading worldwide and the price of oil showing signs of receding.”

And such outlook seems to square or match with the idea the world has been significantly less correlated with the US in the downside and possibly in the upside too.

This very important observation from Mohamed El-Erian, author of When Markets Collide: Investment Strategies for the Age of Global Economic Change and co-CEO of bond-investing giant Pimco (emphasis mine),

``In the old days, if the US economy contracted, the rest of the world would do even worse. But today, if the US contracts, the rest of the world might contract by only half. That's a fundamental change. The wealth of the emerging middle class in countries like Brazil, India and China is becoming a force in itself.”

And perhaps the economic principle that underpins such dynamic is called “The Acceleration Phenomenon”, which was developed by Aftalion a French economist as shown in Figure 4.

Figure 4: Gavekal: The Acceleration Phenomenon

Our favorite Mr. Louis-Vincent Gave has a better description of the Acceleration Phenomenon (highlight mine),

``In China, like in most nations, income is distributed according to a Gaussian pattern (a bell-shaped curve) with a large percentage of the population having an income close to the “average” income. Very few people have a very low income and very few have a very high income.

``If, in China, the purchasing parity adjusted average income in 1998 was US$2,000/year, then the number of people earning more than US$10,000 was have been quite small. But if, by 2003, the average income had risen to US$3,000 per person, then the number of people earning more than US$10,000 will have probably increased by a lot more than 50%.

The above chart shows a hypothetical case. If a country’s average per capita is $10,000 where the elite class (having over $15,000 per annum) comprises 2.28% of the population, an average income growth of 25% will push those in the higher echelon from 2.28% to 15.87% of the population!

The significance, again from the eloquent Mr. Gave,

`` Because we know that when it comes to the buying of certain goods and services, the historical evidence seems to suggest the existence of ‘’thresholds’’.

``For example, if the average income in a country is below US$1,000, nobody owns a television; when the income moves above US$1,000, then almost everybody buys one. For the automobile industry, the critical level seems to be US$10,000/year. For university education US$20,000, etc… Today, as China’s income distribution curve moves towards the right, a number of threshold points are passed by an increasing number of people. A quick example: from nowhere a decade ago, China now counts 210,000 US$ millionaires. The acceleration phenomenon helps explain why car sales rose 64% in 2003. China’s consumption boom has only just started.”

While indeed international channels through trade, capital flows, labor and financial linkages or even monetary pegs could combine to impact an economy, especially in today’s more globalized settings, they don’t constitute everything.

Other significant variables as political, monetary and economic framework similarly determines the internal savings and investing patterns of a country and can present itself as the defining difference to a boom or gloom. As in China’s case a slowdown may reduce the pace of the acceleration phenomenon but generally, the consumption boom derived from such dynamic can lead to a self reinforcing process.

Thus, it is possible that the prospective recovery could even come from a MIRROR progression of the proposed US-OECD-Asia-Emerging Market ranking. Likewise, monetary aspects cannot totally be distinct from economic fundamentals.

Overall, recoupling and decoupling debate should not be seen from an absolutist stand. There will be no perfect decoupling as much as there won’t be perfect recoupling.