It appears that at the turn of the century, US and international equity markets took a solemn oath to move together. Markets have zigged and zagged in sickness and in health over these last seven or eight years.
The last few weeks have been no exception. The subprime crisis caused global markets to tumble in August. Give or take, most markets declined by about 10% from peak to trough and in a very correlated way. And since the Fed changed its discount rate on 17 August, there seems to be a similarly correlated (dead cat?) bounce.
There was a time not so long ago when equity markets were not as correlated. That time began about 13 years ago and was cemented when Asian markets crashed in 1997 in the wake of excessive leverage and overvalued currencies. For example, the rolling one year correlation of daily returns between the MSCI Asia Pacific Index and the S&P 500 Index of US stocks averaged 0.28 from 1994 to 1999, and is at a high of 0.63 today. How things change in a mere decade!
Then, Asian economies and companies were pariahs and America the paragon of virtue. Today, America with twin current and fiscal deficits and excessive consumer leverage and dissaving has switched roles.
In much the same way that the Asian crisis of 1997 marked several years of “decoupling”, I think the subprime crisis of 2007 will precede several years of decoupling between the US and emerging markets. Excessive (dollar) debt in Asia caused that decoupling and excessive (household) debt in America will likely cause this one.
Emerging markets are economically healthy, by and large in the fiscal balance, with strong consumers and healthy (and growing) savings rates. Many companies are debt-free. While a prolonged slowdown in the US will impact net exports of countries such as China, Korea and Taiwan (and perhaps the US exports of some Indian IT service companies), most emerging market economies have enough depth to overcome this shortfall.
The “flat world” believers among you will rush to point out that the world has permanently become more integrated, at least in a financial and capital market sense. Global capital flows, policy conformity and a generally wide sphere of investment for global players has only served to hasten this process. The Americophiles among you will say that as goes the American consumer economy, so goes the world. All true to some degree. Nevertheless, it is possible to have a reasonably long episode of lower correlations in a generalized environment of higher correlations. It is this that I refer to as “decoupling”.
In this episode, diversification away from dollar assets will become not only desirable from a return point of view, but also practically useful from the risk standpoint in building global portfolios.
One significant difference between the Asia of then and the America of today is that the dollar remains the world’s reserve currency. Even through this subprime crisis, the broad value of the dollar has remained quite steady. The dollar’s reserve currency status combined with gradual depreciation is the principal argument for a “slow leak” adjustment of the US economy, as opposed to the vicious adjustment that much of Asia went through at the end of the 1990s.
The decoupling has most likely begun. Debt (particularly when it is marked to market) has a powerful way of sundering apart the strongest of couples.
Narayan Ramachandran is CEO of Morgan Stanley Investment Management, India. These are his personal views. Comment at firstname.lastname@example.org