Emerging Markets and the Decoupling Myth
The narrative over emerging markets is more based on price than reality, and the reality is that price may be wrong.
-- Joseph Campbell
As bullish as many investors are today on the prospects for US equities, they seem to be almost equally bearish on emerging market equities. They justify this viewpoint with the thesis of decoupling. While the US is currently in a "Goldilocks," disinflationary environment, they say, emerging markets are mired in a slower growth, inflationary environment.
This narrative in my view is more a function of recent returns than reality. Over the past three years, US small caps -- represented by the iShares Russell 2000 Index ETF (NYSEARCA:IWM) -- have advanced over 59%. Over the same time period, the MSCI Emerging Markets Index (NYSEARCA:EEM) is down -7% (see chart below). Naturally, the decoupling thesis fits quite nicely for explaining this wide performance gap.
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But how accurate is it, fundamentally, given the facts? While emerging market growth has undoubtedly slowed, US growth has slowed as well, with year-over-year US GDP at its lowest point in the recovery. We have also seen a slowdown in earnings growth to nearly 0% in the past few quarters. This makes sense intuitively as an increasing portion of S&P 500 (INDEXSP:.INX) earnings are derived from overseas. If the global economy is slowing, it is difficult to argue that the US will be immune to that slowdown for long.
We heard a similar argument in late 2007, only in reverse. Back then emerging markets had significantly outperformed US equities over the prior three years (see chart below). Amid signs of a weakening US economy in early 2008, the case was being made by many that emerging markets were insulated from this weakness and would continue to march higher. We all know how this thesis ended. Not only were emerging market countries not insulated economically from a US recession, but their markets were not insulated either. Emerging market stocks declined more than US equities in 2008.
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What we are really talking about, then, is a decoupling in performance, not in economies. This decoupling could certainly continue for a while longer, but I would suggest it is becoming long in the tooth at this point. As we saw with the rapid advance in European markets over the past year, when a recoupling occurs, it often happens quickly.
Heading into 2014, one of two scenarios is likely to play out. First, if the US equity bulls are correct and we are indeed headed for another 1999-type bubble next year, they would do well to refer to the relative performance in 1999. Following significant underperformance in 1998, emerging markets finished up over 63% in 1999, over three times the performance of the S&P 500.
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The second scenario is one in which the US markets recouple with emerging markets by moving sharply lower. Given the current sentiment backdrop (lowest percentage of bears in the Investors Intelligence poll since 1987), this scenario is likely unfathomable to many. But no bull market lasts forever, and we will be approaching the fifth year of this bull market run in early 2014.
In either case, the decoupling myth will likely be exposed once again for what it is: An interesting theory used to justify performance gaps between markets. In an increasingly globalized world, it is far from an economic reality.
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