Stand Clear Of The Closing Doors

One of the harder realities to come to terms with in financial markets is that different rules apply at different times in driving performance.

It's critical to get a fix on the "regime" at work to understand the rules of engagement in any period. Otherwise, as the German theologian Dietrich Bonhoeffer put it: "If you board the wrong train, it is no use running along the corridor in the other direction."

For much of the past year, financial markets have been "decoupling," which means that emerging markets have begun to chart their own course independent of the developed world. All assets linked to the runaway growth of developing countries are on fire, while those tied purely to developed markets are lagging considerably. Emerging-market stocks, which were up 35 percent as of mid-December, are the main factor behind the nearly 10 percent overall gain in global stocks.

However, with the odds of a U.S. recession in 2008 rising sharply in recent weeks, pessimists suggest that a shift to a full-fledged global bear market in stocks is underway. They argue that while the world economy has withstood the 2 percent slowdown in U.S. growth in the past few quarters, a sharper slowdown will lead to a "recoupling" of economic activity between the United States and emerging markets.

Investors now have to make the crucial call as to whether a decoupling or a recoupling regime will prevail in 2008. The rules of engagement under the two regimes would indeed be quite different. If the decoupling scenario extends into the new year, emerging markets could turn out to be the mania of this decade and soar even higher, as investors flock to them in ever greater numbers. On the flip side, if the dictum that "the United States is still all-important" holds true, we are likely to witness a global bear market that spares no asset class.

If history is any guide, the current global expansion still has some time to run. The world economy has followed a remarkably uniform path over the past few decades: The start of each decade typically heralds a new economic cycle, and the rising growth tide initially lifts all the boats. Midway through the decade, central banks begin tightening monetary policy in order to pre-empt any inflationary breakout, and higher interest rates always lead to some financial turmoil. Central banks then start to adopt an easing bias as the priority shifts to avoiding a wider crisis, especially as inflation is not yet a major issue. This sets the stage for a bubble in the few asset classes unaffected by the crisis, as they were never in need of extra liquidity.

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.