Decoupling
カーティス・ミューボーンの略歴はこちらをクリックしください。Amid the worst financial crisis in the post- war period,1 it is reasonable to ask whether several years of strength across emerging markets will be derailed. In the past, a sharp drop in U.S. economic activity and a massive contraction of the global banking system would have almost certainly resulted in a terrible outcome for EM investors. But so far this time, this has not been the case. So what is behind the current situation and what does the future hold for investors?There has been much discussion of a “decoupling” of emerging markets. But what does decoupling mean? To better understand these dynamics, we need to make a distinction between financial market linkages and real economy linkages. Let’s take each of these in turn.Our own set-up here at PIMCO demonstrates the financial market linkages. Our emerging markets team sits on the trade floor along-side our global interest rate, mortgage, asset-backed, credit and other specialist fixed-income product teams. When we look to invest capital for our clients, we look across all areas of the fixed-income markets to better understand what the markets are telling us about the relative pricing of risk and potential returns. Because many PIMCO portfolios invest across many areas, capital naturally moves to the most compelling opportunities from a risk/return perspective. That is why in the August 2007 Emerging Markets Watch2 we argued that no financial market is an island and that the EM asset class would be affected by declining valuations in competing asset classes. For this reason, we conservatively positioned our Emerging Market Bond portfolios.What about the real economy linkages and their impact on investment returns? On these topics you get a very different sense of the likelihood and type of decoupling, depending whether you are on a trading floor in New York, London, or Tokyo or on the ground in one of the EM countries.The view from the trading floors of the developed world tends to be that the probability of economic slowdown in the U.S. and other developed economies will inevitably lead to a slowdown in EM growth. After all, isn’t the U.S. economy the largest, and hence the U.S. consumer, the most significant source of global demand? And hasn’t the “house as an ATM” just eaten their debit card,3 meaning no more flat screen TVs from Asia or luxury goods manufactured in emerging Europe? The prevailing view in this camp is that decoupling is an illusion, and it is just a matter of time before EM economies will relink with the slowing developed economies.At the other extreme, the view from the ground in EM countries is quite different. While conditions vary, there are some common themes that the PIMCO EM team is picking up in their frequent country visits.4 A quote from a recent trip report from Russia captures one of the themes: “I was struck by the bullishness of corporate Russia and the overwhelming focus on domestic demand. The recession in the United States was a distant problem reaching Russia only via the financial channel.”5 On recent team visits to Brazil, Mexico, Poland, and China we have heard the same theme echoed strongly. This is in sharp contrast to the bearish and conservative views that some outside observers have voiced, pointing to previous cyclical downturns in which EM followed the developed world down.So what’s different this time? The single-most-important difference between this cycle and previous ones is that emerging markets as a group are no longer dependent upon external capital flows to finance their own economic growth. More stable domestic financial conditions have helped emerging market countries sustain rapid growth rates amid the U.S. slowdown. The chart below shows the growth of domestic demand across Brazil, Russia, India, China and Mexico (abbreviated as BRICM).
This growth can remain strong because it stands on the foundation that we have written about over the years in Emerging Markets Watch, of stronger fundamentals in the form of lower debt burdens, high reserves, strengthened domestic institutions, and lower inflation. The reduction in government debt has both reduced vulnerability and “crowded in” investment to the private sector. We are now in the early stages of a sustained growth of consumer credit in EM economies, as evidenced by growth of the mortgage markets in China, Mexico and Russia, or the auto loan market in Brazil (Chart 2).
The still-low level of wages in many countries suggests that income gains for emerging market workers and consumers will continue into the future. Over the long-term wage levels in emerging market countries will likely rise to converge with those in the developed economies. As they do the large population countries will become the largest sources of global demand, and in the process of arriving there the economies will have to “decouple” by definition.Notwithstanding the long-term destination, there are many significant challenges on the journey ahead. These challenges come not only from the credit crunch, but also from the need to define the right policy response to inflation using monetary policy and exchange rate tools. On the one hand, following several years of lower inflation, many EM central banks find themselves in the challenging position of facing strong domestic conditions at the same time that global prices for basic commodities – like food and energy – have surged. At the same time, the generous financing environment of recent years has given way to a credit crunch where borrowers – be they corporations, households, or countries – are finding it hard to find credit at low interest rates.Within the emerging market universe, there are critical differences in the capacity of different countries to navigate these challenges. Countries with strong external positions – signified by large current account surpluses and low levels of external indebtedness – can respond to inflationary challenges through more rapid exchange rate appreciation. We are seeing this approach in countries like China and Russia. Witness the Chinese yuan where the pace of the exchange rate appreciation has increased sharply to over 15% annualized recently (Chart 3). Strong balance sheets and strong domestic demand insulate these countries from the contractionary effects of exchange rate appreciation on the economy. Contrast that with emerging European countries like Hungary and Romania that need significant financing for their current account deficits and where domestic borrowers have large foreign currency obligations.
Putting this all together results in two important investment implications. First, no financial market is an island and the credit crunch bells are still tolling loudly. Thus the risks from the credit crunch via financial linkages remains heightened, particularly for those countries with weaker fundamentals and large financing needs, like Hungary, Romania and Turkey. Second, we believe the strength in domestic economic activity across many emerging markets amid sustained weakness in the developed world means that there are selected opportunities in the asset class that were not present during previous global cyclical downturns. Opportunities are attractive in local currency investments of those emerging markets with strong external positions that are using the tool of more rapid exchange rate appreciation to combat inflationary pressures from continued robust growth. Broadly speaking, emerging Asian currencies fit in this category. In addition, local bond investments in Brazil, Mexico, and Poland remain attractive given relatively high nominal and real interest rates.
Curtis MewbourneManaging Director
1 Alan Greenspan, “We Will Never Have a Perfect Model of Risk,” Financial Times 3/17/08.2 PIMCO Emerging Markets Watch, “Never Send to Know For Whom the Bell Tolls; It Tolls For Thee,” August 2007.3 For further information on mortgage equity withdrawal see the Federal Reserve Bank of Dallas, “Making Sense of the U.S. Housing Slowdown,” November 2006.4 PIMCO EM Team conducts on-the-ground visits to update our credit assessments of EM countries and companies. In 2007 we completed 29 trips and so far in 2008 we have completed 8 trips.5 PIMCO Russia Country Trip Report – February 2008 by Portfolio Manager Andrew Bosomworth.
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