In emerging markets, something bad happens every 3 to 4 years, and something very bad happens every 7 to 8 years. Bad things tend to happen when periods of high growth store up imbalances which accumulate till breaking point or hide fundamental structural flaws. More often than not, they are borne from lack of diversification or hedging of risk; or the distortion of the price mechanism and deviations from free markets. Accumulating large foreign reserves, accumulating large trade, current account or budget deficits or surpluses, asset liability mismatches either by currency, duration, credit risk or sector concentration in the financial system or the private sector in general, have been sources of instability. When bad things have happened, emerging markets have largely been left to their own previously often constrained and meagre resources. When aid had been sought from international agencies like the World Bank or the IMF, emerging market economies were largely lectured to about their free market deviating tendencies, their predisposition to running large imbalances and been prescribed bitter medicine as solutions to their problems.

In developed markets cycles are also common, but for the last 30 years they have been muted and policy responses has been swift and effective. For years, Greenspan’s Fed policy of allowing asset bubbles to inflate and then picking up the pieces after the bust, clearly contradictory to the Fed’s non-interference in asset markets, has created an asymmetry of risk and reward for the investor. Everything the Fed does is interference; it is unavoidable for an institution of such power, both real and perceived that its signalling power should overreach its own objectives at non-interference.

Now, incredibly bad things have happened. They began in the US, in a grossly inflated housing market, supported by sub-prime lending, which has now collapsed with it, then spread like a genetically enhanced strain of the flu to infect everyone from Europe to Asia, from Iceland to Australia.

The reaction in developed markets has been remarkable, in particular for the speed with which they have been happy to suspend free market principles in an emergency attempt to ‘keep the patient alive.’ There is some good justification for this course of action.

The reaction in emerging markets has been equally remarkable, in particular for their faith in free markets as the most efficient regime to face the crisis.

When we sat in the eye of the storm September / October 2008, it was consensus that the right thing to do was to temporarily suspend free markets and for governments to intervene in the markets. Had Lehman not failed, had AIG not failed, where might we be? Perhaps they might have failed in 2Q 2009 in any case. We saved the patient, but the patient remains on life support.

The one thing we know about the human species is that it will evolve and adapt. We know that it will emerge from the economic crisis stronger, but we don’t know how and we don’t know how long it will take.

Do we abandon a system which has strong theoretical underpinnings, has actual historical and empirical track record and has served us for so long so well, but which in the short term may have acutely uncomfortable consequences? Or do we stick by it, tough it out and let the lame ducks die? These are not easy choices.

The developed world has chosen a middle ground, choosing to temporarily suspend free market principles, bend Chapter 11, increasingly embrace quantitative easing, further emergency interest rate policy, flirting with protectionism, interfering with the banking system.

Emerging markets don’t appear to have taken the same measures. Their problems are a bit different.

When the world thought about decoupling between emerging and developed markets they mostly thought in terms of the relatively actual and potential growth rates between the two classes, not the phase or the nature of that economic growth and development.

When asset markets in emerging markets fell even harder than those of developed markets, the decoupling theme was quickly shelved. This is a mistake. But so too is looking to BRICs as a panacea and as a saviour of global economic growth. So intertwined has the global economy become that decoupling is not a simple separation of the cycles between emerging and developed markets. It is rather an evolution where the make up of each economy evolves around the make up of the other economies. No longer is it when the US sneezes, the whole world catches a cold. Today, it is that when the US sprains an ankle, the BRICs strengthen their arms.

• Emerging markets are highly export dependent. This is true but to a lesser extent in the BRICs which are large enough to have sufficient diversity and a growing middle class generating domestic demand. Smaller emerging economies do indeed suffer from an over-reliance on exports.

• Emerging market financial systems were not over levered into real estate lending. Again this is more so for the BRIC where scale has brought diversification both in the economy and in loan books. In comparison with US and European banks, this is certainly largely true. Yet again, this may not be true for smaller emerging economies where financial systems tend to be concentrated into one or two industries and in real estate.

• Emerging market households have substantial savings. This is true but developed market savers with a smaller savings ratio might result in more absolute dollars saved. In any case BRICs banking systems have strong and sizeable retail deposit bases from which to lend. An example of this is India, where despite a weaker sovereign balance sheet, private sector lending has held up, precisely for the level of private savings.

• Many emerging markets appear to be maintaining their support of free market practices when in fact they simply began with a less free system. China’s state owned enterprises are still formidable, particularly the banks, which are now being mobilized to increase the supply of credit, not by market opportunity but by degree of the Peoples Bank of China. India’s banks are similarly well supported by a large deposit base and are therefore in a position to extend credit.

• Emerging markets are part of the commodity market theme. Demand for commodities originates in China and India, supply in Brazil and Russia, for example. This is likely to make commodities less sensitive to economic growth in developed countries.

Decoupling hasn’t been so much a myth as an overgeneralization. As long as communications remain open, trade remains robust, labour and capital mobile, the world will continue to be an immensely connected place and everyone will depend on everyone else. A sharp contraction in world trade can disrupt the connections giving the illusion of decoupling. With the credit triggered financial crisis, trade finance volumes have fallen precipitously with a concomitant impact on trade volumes (by a third in the 4Q of 2008). (The causality is questionable in other crises but the scale of the 2008 crisis leaves little doubt as to causality.) Once the situation normalizes, one would expect that economies interrelatedness will reassert itself. This doesn’t mean that decoupling isn’t happening, it means a resumption of an evolution already well underway before 2008.

Part of the recovery and healing process of the world economy will involve an evolution of the trade positions of countries. As profligate nations save and emerging market consumers expand, Western trade deficits and emerging market trade surpluses are likely to contract towards balance. The transactional demand for currency will likely support the USD and EUR while CNY, JPY, KRW, INR weaken. Commodity exporters are likely to see stronger currencies as well, thus AUD, CAD, ZAR. These are longer term themes and short term volatility and news may recommend trading ranges and channels. The risk aversion trade in CHF and SGD is also likely to recede over time but provide interesting range trading opportunities.

The inflation – deflation trade is an interesting opportunity also. From time to time, the market will switch between believing that the world will end in fire, and believing that it will end in ice. With short term interest rates fairly well anchored in the medium term, this will manifest mostly at longer maturities.

For the last 3 months markets have been pricing for inflation. Most yield curves have steepened considerably. A reversal is due both technically and fundamentally. A US treasury flattener, short 2 years long 10 years at a spread of 2.55% is an attractive trade betting that deflation fears will re-emerge and the 10 year will rally. The same trade can be replicated in EUR. This theme is very tradeable as the market fluctuates between inflation and deflation with the added pressure of high volumes of issuance versus uncertain take up from foreign and domestic investors. This spread trades in a range of 1.50% to 2.60%.

The oil and gold trade is one I have followed for some time since oil was 0.16 quanto gold in ounces. At 0.06 oz, oil was a strong buy (relative to gold.) At current market of 0.078, it is also still a buy, however, current market sentiment is likely to see a better entry point. The 6-12 month target for this trade would be 0.12 oz. The range for oil quanto gold is intact. The buying opportunity came from a global de-risking. Despite increased inventory, and this through the recent rally, oil remains a strategic asset. The range established since the second intifada in 2000 is holding well and I expect to continue to hold until strategic developments in the Mid East relax the need to the West to stockpile strategic reserves. On a USD pricing basis, 60 – 70 USD seems to be a sensible range from a demand perspective.

The trade expression in equity markets is more problematic given that there are more moving parts and idiosyncratic risk gets in the way of macro level trades. I am of the view that underlying economies had decoupled by last year even if financial assets had not. We didn’t see the decoupling because asset markets were correlated by ownership. The BRICs were and continue to be export economies and are thus coupled to their trading partners in the West. This coupling is weakened and weakening. The utter slump in global trade is accelerating this process. The West simply has not the capacity to resume pre 2008 levels of consumption. On a relative basis, the trade positions of the West versus the BRICs must change, transforming the BRICs into domestically driven economies. The immediate natural tendency for the private sector is to retrench. Fortunately the state has the wherewithal to fill in the gap and support the process of transition. This is not true of Western state balance sheets. Long growth short value strategies in the BRICs hedged against long value short growth in Western markets is probably a good idea. An outright long BRIC short Developed market is not the best idea because of the relatively higher volatility of the BRIC markets. Trying to hedge both the beta’s and the volatility leads to inconsistent results.

I am not an equity market bear; if anything I am firmly of the view that the world economy is on the path of recovery and repair. Equity markets have, however, run well ahead of themselves and of fundamentals. Technically, equities are heavily overbought. Fundamentally, they are not cheap either. In an earlier article dated 15 June 2009, I suggested that This Equity Market Rally had run out of steam and that a significant correction was probable. 

Equity markets have indeed lost some momentum and some markets have corrected sharply. However, it is too early to tell if this is simply a consolidation before further gains. I do not think so. I believe that we are now firmly in a resumption of the bear market and that 20 – 25% declines are probable in Western markets and 30 – 40% declines are probable in emerging markets.

I am also a firm believer in decoupling of the underlying economies, between emerging and developing markets. So how do I reconcile this with my expectation that emerging markets equities will underperform?

First of all, why do I think that the bear market will resume? The bull market of the last 2 months has been driven by banks, financials, and consumer cyclicals. The dispersion of returns in these sectors has been high. These are sectors with poor earnings visibility and poor predictability of cash flows. In sectors with more predictable cash flows, equity prices have been less, not more, dispersed. In other words, the market has been very news driven, not fundamentals driven; it has been driven by relief rather than conviction; it has been driven by a very thin base and has not been broad based. These are the classic elements of a relief rally, not the underpinnings of a new secular bull market. History has also taught us that markets don’t move in straight lines and that there are basic elements to post traumatic environments. Equity busts have at their roots overvaluation as euphoria overcomes rationality. Weaknesses that were hidden by euphoria eventually manifest resulting in catastrophic loss. Panic ensues. That was last year. Panic turns to despondency and overshooting on the downside. Inventory cycles turn, industrial production surprises to the upside and a relief rally results. These types of rallies can be powerful as short covering reinforces value investing and investors fearing they might lose out. Throughout all this, fundamentals do not feature one bit. By the time they do, the relief rally has outrun fundamentals by a significant margin and its time for a painful correction yet again. I simplify in this example of 2 rallies and 2 crashes but the general principles are there. There can be any number of rallies and corrections but the psychology is pretty much the same.

Technical factors began to show signs of weakness 15 June 2009 across global markets to greater or lesser extent. Only Shanghai markets continued to power ahead. Every one else from DJIA and SPX in the US, the Stoxx and FTSE in Europe, the All Ords, Hang Seng, Sensex, all began to lose steam last week.

On 21 June, the markets began to experience some real weakness. On 23 June 2009, World Bank reduced its 2009 GDP forecast from -1.7% to -2.9% and its 2010 forecast from 2.3% to 2.0%. Developed economies growth was revised from -3.0% to -4.5%. Markets did not like that at all.

Backing up this gloomy view is the fact that there is immense spare capacity in the global economy from developing to developed economies. US capacity utilization for example is below 70%, levels not seen even in the mid 70’s and early 80’s. Unemployment in the US has reached 9.1%, again levels not seen since the mid 70’s and early 80’s. Business confidence has rebounded from its lows but is still very much depressed. GDP is likely to recover in line but again such rebound is likely to be limited. US consumption has rebounded as well but production is still falling. Much of the retail numbers are supported by extraordinary fiscal transfers which are highly unlikely to be repeated, so it is more likely that retail weakens back in line to production than vice versa. US industrial production has fallen by more than has been the case in previous recessions save the Great Depression. For these reasons, it is premature to call a recovery in the US economy and hence US equities for some time yet.

Not all is doom and gloom. There are reasons why the global economy will heal itself. As long as markets are free and protectionism is kept at bay. Emergency measures which might create adverse selection should be quickly reversed. Accommodative monetary and fiscal policy should be maintained until sure signs of recovery are evident. Inflation is unlikely to be a problem for the reasons of spare capacity we discussed. Deflation is unlikely as long as commodity prices can stay near current levels and there is every expectation that they are likely to be well supported. The inflation outlook is likely to be quite healthy, in the old ‘neither too hot nor too cold’ range. The pieces are in place for recovery to take place. However, recovery does not happen in a day. The scale of the damage from the credit crisis was significant. However forward looking equity and debt markets may be, the current rally is simply too much too soon and a correction is well overdue.

Where do we go from here? A simple optical (and linear in log space) analysis of the Dow and the S&P from pre Great Depression times until today would indicate potential downside at about 5600 for the Dow and 650 for the S&P. Are we likely to get there? I think not, but I think that we might get halfway there quite easily. In the assessment of emerging markets like the BRICs it is important to distinguish between beta and volatility. The volatility in emerging markets is such that in a correction, the losses are likely to be higher than in developed markets. The outperformance of emerging markets will likely manifest over a medium to longer term. Intuitively, and quite simplistically, one would be positioned net short at current levels in anticipation of a correction and net long when markets have fallen to more reasonable levels. Intuitively also, a more risk controlled expression would be to maintain fairly balanced books with different growth – value biases in developed and developing markets. A long growth short value position would make sense in emerging markets poised for growth while in developed markets, a long value short growth position would make more sense. Of course micro analyses will reveal richer themes but this is a rational approach to driving the idea generation behind the ultimate portfolio construction.