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.