The Globe and Mail, Report on Business
Published February 9, 2008
In 2007, the capital markets were defined by acronyms (CDO, ABCP, SIV, CDS), but the big new word doing the rounds now is "decoupling". Decoupling refers to an economic theory that says that even though the United States is in recession, the rest of the world will continue to grow and prosper. The decouplists contend that domestic growth in places like China, India, Brazil and Russia will allow the global economy to continue growing.
For money managers, decoupling is one of those issues that has danger written all over it. If you buy into the theory, you're basically saying that "it will be different this time," which are the most dangerous words in investing. They are dangerous because betting on something that hasn't happened before - in other words, a new paradigm - has almost always been hazardous to a portfolio's health. You may ultimately be right in your view, but if the market takes a while to come around to your way of thinking, it can lead to a big performance shortfall and ultimately client losses.
It's also tricky because a manager may ultimately be right in his/her view that it isn't different this time, but if the market takes a while to figure this out too, then the manager can underperform the market. For example, the manager of our Global Equity Fund, Edinburgh Partners, and others like them, left some returns on the table in 2007 by not going along with the decoupling theory.
Personally, I don't buy this decoupling thing either. It reminds me of the arguments being made at this time last year about the subprime mortgage mess and last year's big word, contagion. It was argued by some that the subprime problems wouldn't migrate into other areas of the capital markets. We were told there would be no contagion.
We all know where that went and I think the weakened U.S. economy will ripple through the system as well.
I'm not suggesting that the countries I mentioned don't have lots going for them. As they grow, the American consumer becomes a smaller part of their sales mix. But the United States is still everyone's largest customer, either directly or indirectly.
In arguing against the decoupling theory, Sandy Nairn, the founder of Edinburgh Partners and the manager of our Global Equity Fund, points out that the size of the U.S. trade deficit is almost equal to one-third of China's gross domestic product.
My interest in the topic, and that of other portfolio managers, relates specifically to the ability of corporations of all nationalities to keep expanding their bottom lines in the next two years. What drives markets is the rate of change of profit growth, which in turn is driven by business activity at the margin.
Ninety per cent of a company's sales base may be rock solid, but it is the customers at the margin, the other 10 per cent, who are key. They define the industry dynamic. Do the sellers still have pricing power? Do the weak competitors go into panic mode and dump inventory or slash prices? Does shiny new production capacity become surplus production capacity?
The world economic situation today reminds me of the telecom boom in the late nineties. Everything was roaring along until someone noticed that (1) the big manufacturers like Nortel were heavily into financing their customers and (2) those customers, new and old, were struggling to make money.
In the current context, the United States is the big customer that is being financed by the rest of the world. And guess what, it isn't doing very well. The virtuous cycle that fed on itself on the way up - cheap money, rising prices, more room to borrow, even higher prices, even more room to borrow - has now reversed. Money is as cheap as ever, but Americans don't have the same capacity or appetite to borrow, and the banks aren't going out of their way to make it happen.
Is the importance of the United States in the world declining? Absolutely. I personally am in the "crumbling empire" camp. But is the U.S. so diminished that the world can charge ahead while it is in recession and its financial system is in crisis? I think not. The decoupling argument doesn't recognize how integrated and leveraged our world is today.
It sounds like a good strategy to buy U.S. companies that have significant international exposure, or European companies that are focused on their domestic economy, but if I'm right, it isn't going to matter. A U.S. recession will affect companies of all stripes.
In the meantime, for Canada's sake, I hope my arguments prove to be decoupled from reality, or at least not contagious.