Friday, April 27, 2007

Decoupling: An Economic Cacophony

Someone please help me out with this one.

If other emerging market countries depend on trade with China and China depends on the US (specifically, the US consumer) for much of its growth then, by default, don’t other emerging market economies depend on the US consumer as well? If so, then please advise how decoupling occurs if the ultimate demand source is the US consumer?

Much of the good earnings data discussed (and the supposed source for new highs) centers on global growth originating in other parts of the world as US growth is clearly slowing. In other words, decoupling. This view is gaining among investors. However, there’s a point to consider:

If a major root source of demand is the US consumer and US consumer spending still shows little to no effects of the broad economic slowdown, then has decoupling really been put to the test*?

There are two economic issues that will determine the direction of earnings growth – the US economy and decoupling. If the former turns out to be worse than expected or if the latter falters, then the markets may be in for a surprise as the year progresses. Given the rising degree of investor expectations that the US is in the midst of a soft landing, that 2H07 earnings will rebound substantially, and that the valuation gap has closed substantially, the risk of disappointment is on the rise.

But there is also the related, and larger, issue at work here – interconnectiveness.

Investment Strategy Implications

It has been argued on this blog and in my reports that a feedback loop exists today the likes of which the world has never seen. Globalization has produced great economic benefits at a price – we are all in it together. Growth depends on markets that are developing (many of which are quite immature on multiple levels). And as long as economic progress continues in a benign fashion, the extraordinary growth of the past several years stands an excellent chance of enduring.

However, to use a musical metaphor, that presupposes that the global economic symphony will continue to make sweet music. And, should decoupling occur, synchronized economic growth must give way to a harmonized tune of disparate ensembles, each making their own sweet music**.

Decoupling may accept the musical baton and harmony may emerge. However, while that musical test has yet to happen, the markets are acting as if it is a done deal. Beethoven gives way to Duke Ellington and Eminem.

I wonder how many investors are prepared for the cacophony that decoupling will produce?

Have a good weekend.

*This point was recently raised by Steve Roach and in the IMF World Economic Outlook report.

**The trade version of this is the Doha round is replaced with numerous bilateral agreements. The risk is trade factions can form resulting in, what in effect are, economic tribes.

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