Commoditizing the Decoupling Theory

The theory of decoupling suggests that emerging markets have broadened and deepened to the point that they no longer depend on the United States for growth, leaving them insulated from a U.S. recession.

Several analysts have claimed that decoupling is a load of rubbish, while others swear by it. One of the factors complicating the decoupling debate is the lack of agreement on a definition. If we look at the performance of emerging market stocks over recent weeks, it appears decoupling is a fairy tale. But arguing that a falling stock market signals an economic downturn is too simplistic since there are many factors that can lead to selling of stocks. That being said, decoupling is essentially a theory about how commodity prices react to a U.S. recession.

Conventional wisdom suggests that when the U.S. economy sneezes, the rest of the world catches a cold. Conventional wisdom suggests that a U.S. recession will knock down global growth, thereby reducing demand for commodities, a vital economic input. With lower global demand for commodities, prices fall. "Whatever the conventional wisdom is, you should question it, because it's probably wrong," warns legendary investor Jim Rogers. Is it possible that commodity prices will keep moving higher even if the U.S. economy goes through a nasty recession?

For all that has been said about the theory of decoupling, this is probably one of the big questions that will soon be answered. Many emerging markets depend on commodity exports, and growth and prosperity in the emerging economies also drive trade amongst them. Growing trade among emerging nations boosts demand for commodities, keeping commodity prices high.

The feedback loop is one of the foundations of the decoupling theory, and it is important to understand that this feedback loop occurs outside of the U.S. economy. As a recent article in The Economist points out:

* Emerging markets collectively send more than half their total exports to other emerging markets. "China's growth in exports to America slowed to only 5% (in dollar terms) in the year to January, but exports to Brazil, India and Russia were up by more than 60%, and those to oil exporters by 45%," says The Economist. "Half of China's exports now go to other emerging economies. Likewise, South Korea's exports to the United States tumbled by 20% in the year to February, but its total exports rose by 20%, thanks to trade with other developing nations."

* Emerging markets as a group now export more to China than to the United States

* IMF data make clear that in 2007, India and China accounted for more global growth than the U.S.

* The four biggest emerging economies, which accounted for two-fifths of global GDP growth last year, are the least dependent on the United States: exports to America account for just 8% of China's GDP, 4% of India's, 3% of Brazil's and 1% of Russia's.

* Trade surpluses have allowed emerging markets to build up $3.2 trillion in foreign exchange reserves ($2.1 trillion, excluding China), which provides a strong buffer against any credit market disruptions in the developed world. Assuming that emerging market fundamentals remain relatively insulated from developed world credit troubles, trade between emerging nations will flourish and demand for commodities will remain high.

If "decoupling" is for real, a U.S. slowdown will have a limited impact on commodity prices, since trade among emerging markets will boost global growth and support commodity prices. But don't get me wrong, decoupling does not mean that a U.S. recession will have no impact on commodities. The point is that commodity prices will slow down by much less than in previous American downturns. In other words, if you are a true believer in the theory of decoupling, it makes sense to buy commodities at these elevated levels.

On the other hand, a dramatic collapse in commodity prices could do some real damage to emerging economies. Lower commodity prices will reduce the income of emerging economies, and the theory of decoupling will probably implode into a reality of recoupling.

Several analysts blame rising commodity prices on the weakening U.S. dollar, arguing that commodity prices will quickly collapse if the dollar normalizes during the second half of the year. The dollar's influence on commodities cannot be dismissed, but it should be noted that demand for commodities remain strong even when we remove the dollar's effect by pricing commodities in euros (see the ascending triangle pattern on this chart). Going by this logic, a rebound in the U.S. dollar may have a limited impact on commodity prices, and the theory of decoupling may still have some credibility.

When discussing commodities, there are also long-term forces to consider. It can be argued that these long-term forces may have a bigger impact on commodity prices than near-term weakness in the world's biggest economy. The recent Barclays Capital Equity Gilt Study plunges into an analysis of the supply and demand for commodities and the implications for the world in which we live. "Its analysis is not for the faint-hearted," warns Anthony Hilton at the Evening Standard.

"Assume, for example, that Chinese and Indian consumption of oil rises over the next 25 years to current U.S. levels, while the rest of the world takes no more oil at all. China and India alone would then consume 160 million barrels a day, against a total current global demand of 85 million barrels."

"Global demand at that point, including the rest of the world, would be three times today's level, at 240 million barrels a day. If that amount could actually be produced - a big if - it would exhaust all current proven oil reserves in 15 years, and all the other weird stuff like Canadian tar sands in 26 years," says Mr. Hilton.

Scarce commodities will one day go to the highest bidder, and the raw efficiency and high savings ratios of the Asian nations mean that they will be that highest bidder. "We in Europe, and the U.S., could be priced out of the market," concludes Mr. Hilton. "The interesting thing is how the Americans will react to this. The lessons of history are not encouraging, because military power lasts longer than economic power."

In summary, decoupling theory can be seen as a theory about the relationship between commodity prices and the U.S. economy. The theory makes sense if commodity prices remain elevated during a U.S. slowdown, but recoupling may become a reality if commodity prices collapse.

Comments

[PADDYWHACK]

Great post,this was a hot topic in Europe when I was there.Europe is not decoupled but BRIC is closer to this and American influence will weaken.We moronically spent trillions for not one extra drop of oil and now will be paying to avoid a total loss of face for years,100 if McBomb has his way.It is a pivotal time and waving our national schwanz at everybody while borrowing from our competitors does not seem to be a good plan.We are still a great military power but so was England until an economically surging Germany showed up.We made a huge profit on that little dustup as others are now raking it in on our missteps.The costs of all this will break us as it did our competitors.Time to be realistic and try to salvage our butts.

[MilwaukeeDan]

Wow, 4 comments on this very informative blog. Next time, use the title "Wild Teen Group Sex", it's the only way Americans will read important info.

[Idytme]

"commodities" is a very inclusive word. If you were talking just about wheat, for instance, I would say that the price wouldn't have a lot to do with our economy. Some of what is influencing the prices are : the fact Saudi Arabia has announced that they will slow down and stop producing wheat (they were an exporter), wheat rust has been found in many more African/Middle East countries this year - where 25% of wheat is produced, last year's Australian drought affected supply and there is no guarantee they will be back to normal.
Corn would be another, since it is now being used for fuel, China is going to become a net importer this year, Russia wants more corn for livestock, etc.
In otherwords, what will be driving these prices is scarcity.
I have also read that scarcity was driving the price of copper.
But as people invest in more commodities the question is if the producers and manufactures get priced out of the market by the speculators and the market stalls.
I think we need to speak about commodities in smaller groups, like fuel, metals, materials like cotton, meat and grains. I think each will have its own rules and price cut off points.

[PacificGatePost]

Worrying about the future without action is not constructive. It's time to rebuild and it should happen from the bottom up.

http://pacificgatepost.blogspot.com/2008/02/rebounding-us-economy.html

Government leadership seems absent. Start with getting a our of Iraq then start saving the nickels and dimes.

[January]

So, then, is the current price of oil evidence of decoupling? We are bidding against not only our traditional rivals for commodities in the West (plus Japan) but now also against the emerging economies in the East? And so long as there is little or no social disruption in the emerging economies, their rivalry with us will increase.

Those statistics about the rapid increase in depletion of oil are dramatic. I see no evidence to doubt them. We have come to a turning point in the world economy. Is anybody in America listening?

[MilwaukeeDan]

Mr. Esterhuizen, complex, but great post. January, no one in America is listening. I have been asking this question for months in the business section of Huffpo with no answers. Question: What happens to the price of oil and our economy once the emerging markets(China, India, Indonesia, Russia, Vietnam,ect, over 2 billion people) get rid of their bikes/mopeds and start purchasing cars by the 10s of millions? How will they heat their homes and businesses? Who was the big global player who brought these countries into the 21st century(making them their manufacturer)? Why are all the world auto giants all over the Chinese market(US companies are shutting plants here, but investing billions in Chinese plants)? Sales of the expensive/complex BMW 7 Series are highest in China.

If you have been following the Russia/US relations over the last 7 years, you can see the United States and England have tried their best to start a war with Russia. Pushing NATO eastward. Recognizing Kosovo against Russian wishes. They keep harping about freedom and democracy, but it's all about Russian natural gas and vast oil deposits. Remember the oligarchs during Yeltsins reign? Installed by Clinton's goons. I have said this in the past, the 21st century will be controlled by those that have energy, those that don't will have to fight and die for it, think about why we're in Iraq. In the late 20th century, we were all over the globe fighting communism, in the 21st century, we'll be fighting for oil, as we are now.