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Decoupling Debate

Some managers say emerging markets can soar even if developed economies stumble.

Globalization has drawn the world’s economies closer together, but shifts in trade flows may be loosening the links between emerging markets and the developed world. According to Arjun Divecha, head of emerging markets at the Berkeley, California, office of Boston-based asset manager GMO, as the emerging markets trade more with each other, they become less dependent on developed nations for their growth. “If you have a mild recession in the U.S., Chinese growth in domestic consumption can still be robust,” says Divecha, who joined GMO in 1993 to set up its emerging-markets equity operation, a business that manages about $20 billion today.

Divecha points out that the proportion of emerging-markets exports destined for the U.S. has tumbled from 28 percent seven years ago to less than 20 percent last year, while exports to other emerging markets have shot up from 15 percent to 25 percent in the same period. The raw numbers don’t tell the whole story because they include shipments of raw materials and components that may be reexported to the U.S. in finished products, but nevertheless, the emerging markets depend far less on the U.S. than they used to. “The U.S. has been doing pretty badly in the past year, but steel prices have doubled,” says Divecha. “If that’s not decoupling, what is?”

Not everyone buys the decoupling argument, however. Mark Mobius, a longtime investor in emerging markets and a portfolio manager at San Mateo, California–based Franklin Templeton Investments, says: “There is no such thing as decoupling. Something happening in Europe or the U.S. or China or India is going to impact everybody else one way or another.” His enthusiasm for emerging markets is undiminished, however: He expects them to grow by 6 to 7 percent in 2008, versus developed countries’ 1 percent. Decoupling may be a myth, but even if Mobius is right, the correlation between emerging markets and the rest of the world has certainly become more tenuous. Mobius notes that emerging markets are a widely divergent group and large economic trends like rising commodities prices affect each of them differently. Although high prices benefit raw materials exporters like Brazil and Russia, Mobius points out, they create headaches for net importers like China, India, South Korea and Taiwan, countries that are still growing fast.

Simon Hallett, chief investment officer at Harding, Loevner Management, a Somerville, New Jersey–based money manager with $6 billion under management, including $3 billion in emerging markets, stresses that investors have to look at what drives the economy in each case. For example, Brazil has won acclaim as a commodity producer — for the first time in its history, it boasts an investment-grade credit rating and has a net capital surplus. Although it exports iron ore and will have huge opportunities for agricultural exports if tariffs come down, Hallett notes that it remains a net importer of oil.

David Lazenby, head of the emerging-markets team at Boston-based Batterymarch Financial Management, reckons it’s only a question of time before commodities prices stop climbing — and perhaps reverse. Some emerging markets will face a more difficult environment, but Lazenby doesn’t expect a repeat of earlier financial crises. There are exceptions, of course: He points to Venezuela under Hugo Chávez, for example. Although Lazenby acknowledges that emerging markets have made enormous progress, he doesn’t believe they have decoupled from the developed world. “The fundamentals are very strong right now, and that justifies a different valuation level,” he says. “But it makes me nervous when people say that emerging markets are a safe haven.”

John Chisholm, portfolio manager and co–chief investment officer at Boston-based Acadian Asset Management, shares Lazenby’s reservations. Favorable regulatory, tax and transparency policies promote trade and, in the long term, convergence between emerging and developed markets, but he believes the virtuous circle is fragile. “If we had a major global recession, the growth would take a big hit in the short run, and then you would see some backsliding,” Chisholm says. “Markets sometimes go off the rails because of poor policies initiated at the top.” It isn’t just authoritarian regimes like Myanmar or Zimbabwe, either; Argentina has a democratic government that “has pursued poor policies for decades,” Chisholm notes.

Stock markets don’t always reflect underlying economic fundamentals, of course. Mark Edwards, an emerging-markets portfolio manager at T. Rowe Price International in London, suggests that developing countries have decoupled to some degree at the macroeconomic level, but that their stock markets won’t escape unscathed if the U.S. goes into recession. “During a serious financial wobble like there was in March, all markets will suffer,” he says. “And the high-beta emerging markets generally will fall faster.”