Stand Clear Of The Closing Doors

By the end of the decade, the whole cycle begins to unwind, with inflation becoming a greater problem as productivity gains diminish, in turn forcing more concerted central-bank tightening.

For this decadal pattern to recur, the two necessary conditions are that the U.S. Federal Reserve—in its capacity as the world's leading supplier of liquidity—keeps easing monetary policy and that growth remains robust in the developing world. The counterintuitive point here is that any monetary easing will likely benefit emerging markets more than the United States, since it is difficult to reinvigorate a fundamentally weak U.S. economy at so late a stage of the cycle.

Under such a scenario, emerging-market stocks (which in valuation terms are at parity with developed-market stocks) could end up trading at a significant premium. This is the classic late-cycle story of liquidity chasing an increasingly limited number of opportunities, thereby driving valuations of the growth segments of the market higher and higher.

The current decoupling regime will be truly threatened if central banks in emerging markets start to aggressively tighten monetary policy to curb inflation, or if the Fed too is constrained from supplying more liquidity due to similar concerns. Otherwise, developing countries should be able to weather any softening in U.S. demand, especially given the fact that they now constitute a larger part of the global economy than the United States and are expanding at four times the rate of the developed economies. In fact, the feedback loop between the U.S. and emerging markets now works the other way around (as was the case this past year), with strong economic momentum in export markets shoring up U.S. growth and offsetting some of the weakness in domestic spending.

What bears close watching, then, are inflation trends in both emerging markets and the United States. If policymakers—particularly in the world's main growth engine, China—are forced to shift their priority toward curbing inflation rather than letting their economies boom, then the emerging-market story, too, will crack, and growth will recouple or converge on the downside across regions. For the time being, inflation is concentrated in food prices, and in the past, at least, that has proved to be a transitory phenomenon. The operating assumption, then, is that decoupling is still at work. That said, the journey aboard the decoupling train is likely to be a rather tense affair in the new year, as with a little more inflation, this could well be the wrong train to be on.

Sharma is head of emerging markets at Morgan Stanley Investment Management.

© 2007