Crisis shows links not broken yet

Experts have said for years that emerging markets were breaking free of their lock-step movement with developed markets.

But the market crisis changed that view. While few believe that emerging markets are as dependent on developed economies as they were 10 to 15 years ago, these developing economic engines are not yet strong enough to pull the world — or even themselves in some cases — out of recession on their own.

But contagion also goes both ways, and developed economies at least sneeze if not fall ill themselves when emerging markets catch a cold.

“The decoupling argument is (based on) a historical view that dictates that the (U.S. and other) core markets impact the peripheral, emerging markets, but not the other way around,” said Jerome Booth, London-based head of research and a member of the investment committee at Ashmore Investment Management, which had $31 billion in assets, mostly in emerging market debt, under management as of Sept. 30.

“The reality is that the periphery impacts the core (markets) in a big way.”

Prior to the economic crisis, the notion that emerging markets perform independently of the G7 economies — led by the U.S. — had been growing for a while.

Following the subprime mortgage debacle that emerged in the summer of 2007, some investors still believed that certain emerging markets — with its their robust growth and giant reserves — would be cushioned against the painful blows dealt to developed markets.

But the September 2008 collapse of Lehman Brothers Holdings Inc. dispelled any such wishful thinking as emerging markets also nosedived in the aftermath.

The Brazil Bovespa stock index fell 40% to hit a record-low within about 40 days, while China's CSI 300 index also plummeted by about 18% also to reach a bottom within two months after Lehman Brothers declared bankruptcy on Sept. 15, 2008. While China and Brazil began recovering from their lows in late 2008, both the Bombay Stock Exchange Sensitive index and the Russell 3000 Index didn't turn around from its lows until March of this year, after having fallen 40% and 44%, respectively, from the pre-Lehman levels.

As certain emerging economies — namely those in Asia and Latin America — have outperformed major economies so far this year, the decoupling argument is again resurfacing. The Bovespa stock index returned 53% this year as of Sept. 30, compared with just 15% for the Russell 3000. China's CSI 300 index was up by 65% while the Bombay Stock Exchange Sensitive index gained 71% during the same period.

“There's no doubt that we're seeing a switch in industrial firepower to emerging economies — most notably to China and India but not necessarily limited to those markets — from the more developed markets,” said Anne Richards, chief investment officer and head of multiasset investment at Aberdeen Asset Management Co. in Edinburgh. “That trend is not going to change anytime soon.”

Most managers and consultants interviewed argued for stronger growth among emerging markets compared with the developed economies to continue for at least the next five to 10 years, but few bought into the decoupling argument. For the most part, they questioned the whole decoupling-recoupling-decoupling development with skepticism, pointing to China's traditional reliance on exports for GDP growth.

Yet emerging markets also don't necessarily move in tandem with the economies of the U.S., Europe or Japan, as seen in the recent rally. Reflecting the outpaced growth, emerging markets do offer more attractive risk-adjusted returns, according to managers and consultants.

“Certain emerging markets, especially China, are starting to have a life less dependent on the Western world to maintain their economic growth,” said Peter Preisler, director and head of Europe, Middle East and Africa at T. Rowe Price Group Inc. based in London. “As we saw during the crisis, the financial sectors may be tightly held together on a global basis, but the economies are not so tied. There is a certain level of decoupling.”

However, for emerging markets to be truly independent of the developed economies for growth, domestic consumption must reach a much higher level than it is now, said George Hoguet, managing director and global investment strategist specializing in emerging markets at State Street Global Advisors, Boston.

“It's a multiyear process that will depend on the development of a stronger social safety net, pension system and political structure among other things,” Mr. Hoguet added. “It's a function of risk aversion among Chinese investors and consumers.”