Global Equity Markets: Decoupling or Recoupling?

Many have come to believe that the outperformance of ASEAN markets represent signs of decoupling.

BCA Research argues otherwise and observes that the “average correlation between national equity markets has trended higher over the past decade”

They add, (bold emphasis mine)

Equity market correlation reached a peak during the 2008 financial crisis, and what eventually led to the largest global easing episode in history. But correlations still remain high and this suggests that the benefits of diversification are dwindling as investors shift between asset classes rather than between regions in response to market events. It is unlikely that the period of high correlation will end soon. The importance of macro events/drivers (government deficits, financial system health, emphasis on monetary stimulus) over the past decade has been rising and will be an ongoing feature on investors’ radar screens for years to come.

Worth noting:

1. Intensifying globalization has made financial markets more correlated and not less. Hence the above average activities seen in ASEAN or many emerging markets represent outperformance and can hardly be construed as strong indications of decoupling.

And the above dynamic seems also reflected in terms capital flows on direct investments (chart from Google Public Data).

In other words, cross border movements of capital has intensified similar to scale of improvements in world trade. I see this as financial globalization.

And as we have repeatedly been saying, the decoupling is dynamic that has yet to be proven. This will only be evident when global markets and the economies come under duress and not during inflation driven booms.

2. Since the world has been more integrated than in the past, macro dynamics will equally play a bigger role in determining trends in the financial markets or in economic developments. The relevant macro factors will perhaps depend on the proportion or the extent of a country’s exposure to world integration or globalization. And this is where the variability in national performances would emerge.

Has The Deleveraging Process Culminated? Where’s The Next Bubble?

``Many shall be restored that now are fallen and many shall fall that now are in honor.”- Horace, leading Roman lyric poet in Ars Poetica

Global markets rallied furiously over the week, setting stage for what perma bears call as the sucker’s rally. For all we know, they could be right. But I wouldn’t bet on them. Not especially when central banks start to use the first of its available nuclear option of monetizing government debt. Not when government central banks start running the printing presses 24/7 and begin a Zimbabwe type of operation.

We also don’t know to what extent of the forcible liquidations of the deleveraging process is into, what we do know is that governments are today starting to unveil their long kept ‘secret’ final endgame weapons. We appear to be at the all important crossroads. Will it be a deflationary depression outcome? Will it be a recovery? Or will hyperinflation emerge?

What we also know is that forcible liquidations from the ongoing debt deflation process have been responsible for the “recoupling” saga we are seeing today.

Figure 4 stockcharts.com: Gold leads Rally

In figure 4, compared to the previous failed rallies (2 blue vertical lines), gold, oil and commodities haven’t joined the bullish rebellion in global equities as shown by the US S & P 500 (spx), Dow Jones World (djw), and Emerging Market Index (EEM).

This time we see gold leading a broad market rally. The Philippine Phisix too has obliterated its 10.73% one week loss by surging 11.65% this week. And even our Peso has joined the uprising by breaking down the psychological 49 barrier.

In short, this week’s rally does look like a broad market rally. And broad market rallies usually have sustaining power.

The Philippine Stock Exchange’s market internal tells us that even during the other week’s meltdown, the scale of foreign selling appears to have diminished. It had been the local retail investor jumping ship. This week’s rally came with even less foreign selling even if we omit the special block sales of Philex Mining last Friday.

My ‘fallacy of composition’ analysis makes me suspect that perhaps the issue of deleveraging has ebbed, simply because as the US markets cratered to form a NEW low, just about a week ago, key Asian stocks as the Nikkei 225 ($nikk), Shanghai composite ($ssec) and our Phisix have held ground see figure 5.

Figure 5: Stockcharts.com: Asian stocks Show Signs of Resilience

To consider, even as streams of bad economic news keeps pouring in, as Japan has reportedly entered an official ‘technical’ recession or two successive quarters of negative growth, its main benchmark the Nikkei appear to be holding ground.

It’s been said that once a bear market has stopped being weighed by more streams of bad news or despite this they even begin to rise; this mean that markets may have digested all negative info and may have signaled that a bottom has finally been established. As we quoted Jim Rogers on a video interview, ``When people say it is over and when we you see more bad news and stocks stop going down. But when they go up on bad news, that’s when we are gonna hit bottom. We are not gonna scream I don't know."

Although it could be too premature to decipher recent events as a bottom, we’d like to see more improvement in the technical picture and even more participation from major benchmarks of the region (djp2) aside from sustained rise from the market leader-gold.

Furthermore, if indeed the deleveraging process is beginning to fade, then the next phase should be markets factoring in the repercussions from the recent credit crunch to the real economy. But considering the steep fall during the October-November carnage, it is our impression that most of these had already been factored in.

Moreover, the downturn in the real economy should reflect divergences because not all of the Asian region’s economy will experience recessions see figure 6.

Figure 6 IMF: Emerging Asia Quarterly Growth Forecast

As you can see from the IMF’s regional outlook, except for Industrial Asia (Japan, Australia and New Zealand) which is the only class expected to flirt with an economic recession 2009, the rest of Asia’s economic growth engine is expected to only moderate with the Newly Industrialized Economies (Hong Kong Korea Singapore Taiwan) experiencing the most volatility (steep fall but equally sharp recovery). Most of the Asia is expected to strongly recover during the second half of 2009.

Now if the IMF projection is accurate and if stock markets are truly discounting economic growth to the streams of future cash flows of companies, then we should begin to see today’s rally as sustainable, reflective of these projections and at the bottom phase of the market cycle.

This also means sans further deleveraging prompted liquidations, we could expect some stark divergences in market performances. Unless, of course the headwinds from the collective efforts to inflate impacts every asset class simultaneously, which we think is quite unlikely. But as we earlier said, the bubble structure in the US isn’t going to revive and that any new bubble will come from elsewhere, for example the US dot.com boom bust cycle shifted to the housing industry in 2003 as an offshoot to the inflationary policies applied against a deflating tech industry led market and economic bust.

Boom-bust market cycles always involve a change of leadership. And considering that gold has been the frontrunner during the recent bounce, we suspect that precious metals, energy, commodities, emerging markets and Asia as the next bubbles to blow.

Global Recession: Reading From Individual Actions Than From The Collective

``Here’s the truth: voters naively think (or hope) that one man has the right answers in the right plan. It's not possible. Presidential policies are way too simple in a world way too complex to be prescriptive with any certainty in their consequences. Stuff happens. I believe the only thing a single man can do before an audience is this: get their attention; move them to action. Influence. Change their psychology. Make them positive, make them hopeful, inspired, make them motivated. Make them act. We don't have to agree with the words of history's greatest orators, but we can't deny they moved people. Mostly for the better (Cicero (before senate in Rome), Jesus (Sermon on the Mount), Patrick Henry (liberty or death), Lincoln (Gettysburg + Inaugural Address), FDR (fear speech) Churchill, Kennedy (Ask not and Moonshot), MLK (I have a dream), Reagan, even—Al Gore created an entire movement, with a slide-deck). Make no mistake: history is littered with corrupted power, jingoistic rhetoric, misguided promises and words wielded with malicious intent from galvanizing speakers (Hitler, Stalin, Castro, Chavez) who took a broken people and raised their spirits and moved them to action--and to atrocities--in the completely wrong direction.”-Josh Wolfe, Words Matter

***

Recession has been the de rigueur word in the web sphere. The more the clarion the call for a global recession, the more public’s attention seems to have been drawn to this. The debate has apparently shifted from one of the probability of occurrence to one of severity and duration of the “established” event.

While it is true that what seem to ail the world today have been imbalances that have been fostered throughout the years, it isn’t clear how these “malinvestments” should result to cataclysm on a global scale.

The worst part is that the penance from the sins of one clique is seen as similar penitential discipline to the others whom have not committed the same iniquities. Thus, because of connectivity or “recoupling” we are told, we ought to prepare for Armageddon.

We learned from the Austrian school that because people are rational and thinking individuals guided by reasons to our every action, the diversity of the individual’s marginal utility or our “values” may generate different responses to even similar circumstances that we are faced with. Seen from the real world perspective, where circumstances are distinct for everybody, the responses from individuals are even more complex and disaggregated than can be comprehended by “articulate self-righteous” aggregate looking Keynesian assimilating experts.

As Jim Fedako of the Mises.org recently wrote, ``the concept of the individual must never be lost amid the ideal of the collective — the belief that the members of the collective (the nation in this instance) are faceless automatons dedicated to serving the whole.”

Such divergences can be seen even from governments themselves.

Many have argued that deteriorating conditions in the external trade and financial linkages would lead to central banks’ conventional response of cutting policy interest rates. During the last crisis, European central bankers followed the steps of the US Federal Reserves; faced with a recession in 2001 the US Fed slashed policy rates to 1% while the European Central Bank cut similar rates to 2%. Recently, as the US Fed cut an aggregate 325 basis points on the advent of the credit crisis, the Europeans refused to follow. And many have been puzzled by the ECB’s persistent recalcitrance.

In June, Wolfgang Munchao (at the Financial Times) sees this in the light of evolving geo-political economic dynamics (highlight mine),

``This suggests that in terms of global monetary policy, we are in the middle of a shift from a unipolar to a bipolar world. In the past, the Fed’s policy alone used to determine the global monetary policy stance – via the dollar, the global anchor currency. Through long periods of loose monetary policies, including lengthy episodes of negative real interest rates, the Fed contributed directly to the rise in global inflation. I am not referring to the recent commodity price increases but to the trend rise in inflation we have been observing for some time.

``European inflation has also risen as part of this global trend. If the ECB follows the course Mr Trichet appears to have set out, there is now a real possibility that the eurozone, and perhaps some other regions in the world as well, could decouple from this US-led trend. This is what I mean by policy decoupling.”

While the ECB might belatedly respond to the lowering of interest rates considering rapidity of declines in economic conditions, this isn’t at all certain. The Bloomberg quotes European Central Bank council member Axel Weber as saying in an interview in that ``there's no scope for interest-rate cuts and the bank may even need to raise borrowing costs again once the economy emerges from its slump.”

All this goes to show that the decoupling recoupling debate is nothing but abstractionism that won’t attain absoluteness simply because nations interact with each other and at same time retain distinctiveness in terms of domestic activities. In the same manner arguments which leads to a global meltdown based on such premises should also be seen with skepticism.

Look at how the world has defied such conviction, e.g. one year into the US-Euro credit crisis impelled global economic slowdown, Germany’s exports continue to account for positive growth whereas the country’s economic slowdown has been due to slowing domestic demand (Wall Street Journal). In other words, Germany’s present weakness has been in the account not because of external linkages but from domestic strains allegedly from “high consumer prices” and not the externally presumed cause-and-effect factors.

Or look at Japan’s recent exports see figure 1.

Figure 1: Danske Bank: Asia leads Japan’s exports

The conventional analyses have focused on deteriorating export markets of US and Europe as one of the reasons for marking down Japan. But just recently China has emerged as Japan’s top export destination (IHT). The Dankse chart shows how the growth clip of Asian exports (blue) have remained resilient (or rangebound) in spite of the sharp volatilities in the US (red) and the European market (apple green).

Of course, we don’t deny that present developments may lead to the belated reactions in both Japan and Germany relative to external links as the downshift from global economic growth spreads, but the lesson is clear: If governments-organizations controlled by a few individuals-can’t get their act to be as predictable for the gloom-and-doom advocates, how much more when we deal with markets.

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.