The idea of decoupling gained prominence in 2006, and achieved superstar status in early 2008, as emerging markets boomed. Advocates of decoupling professed that the rising prices of commodities, which overnight turned many third-world countries into boomtowns, let these long-neglected economies decouple from the G8 and other industrialized nations. By decoupling, they could finally set their own economic destiny.

Well, if there is any economic theory headed for the trash heap it’s decoupling. That’s because, as the markets have proven, young economies are largely dependent on more mature industrialized economies for their financial survival.

Cash, credit and construction fed the so-called Commodity Supercycle, which pushed emerging markets to all-time highs over the past few years. Now that cash, credit and construction are gone, investment opportunities in emerging markets look bleak for 2009.

For example, the Financial Times reported yesterday record volumes of government bonds from the industrialized nations could crowd out emerging markets from a shrinking pool of credit.

Some $3 trillion in government bonds expected to be issued by the big developed economies in 2009 – three times more than in 2008, the FT wrote.

The timing couldn’t be worse for emerging markets. Not only do they need to repay record debts, but they are also dependent on credit to fund new capital-intensive ventures in mining, exploration and drilling so they can be responsive to an eventual turnaround in global markets.

This creates an environment for a new rash of sovereign defaults – turning back the clock by decades on countries in Latin America, Eastern Europe and Asia.

For investors, emerging markets could be a roller coaster ride at best.

As decoupling proves to be a false idol, emerging markets have clearly proven how closely tied they are to the U.S. and Europe.

With that in mind, the International Monetary Fund issued a forecast last week that said U.S. economic growth will be close to zero for the rest of 2008 and the few months following.

The IMF expects a gradual recovery in the U.S. starting in Q2 2009 – an outlook shared by most advanced economies.

Bottom line for emerging markets is that they will continue to be crippled by the global financial contagion at least through the first half of next year.

“The export statistics are serving as evidence of an economic theory known as ‘decoupling,’”, writes Jason Simpkins in Money Morning, “in which emerging markets in Asia and Europe have developed enough market place muscle to no longer be dependent on the U.S. economy for growth”.

And ‘decoupled’ markets can survive – and even thrive – even if the United States were to spiral down into a recession.

The report ’suggests that those saying that exports are collapsing are wrong,’ Stephen Green, head of China research at Standard Chartered Bank PLC in Shanghai, said in a report.

Trade did grow with the more mature economies of the West. But China got its biggest boost from such emerging markets as India. Two-way trade with India increased by 70% in the first five months of 2008, the fastest rate of growth among China’s Top 10 trading partners.

China is also forging stronger ties with Latin America. In 2004, Chinese President Hu Jintao predicted that Sino-Latin American trade would reach $100 billion by 2010.

In reality, it reached $102.6 billion in 2007, surging 42% from the year before.

The fact that Chinese exports have more than weathered the global financial storm is a huge blow for critics who had earlier predicted this credit-related mess would cause China to stumble.

China’s economy grew by 10.6% in the first quarter of 2008, despite complications stemming from the U.S. credit crunch, the Chinese New Year and the worst ice storm the country had seen in decades.

‘We have a lot of evidence to support the decoupling view,’ Timothy Bond, Merrill Lynch & Co. Inc.’s (MER) chief Asia economist, said in a research note.

Indeed, the recent surge in exports is proof that China will continue to advance – with all but a complete collapse of the U.S. economy. The growth in sales overseas sales, regardless of what happens in the United States, but they also proved that Chinese trade isn’t dependent on the weakness of the yuan.

For years, the United States and other Western powers have claimed that China has kept its currency, the yuan, artificially low to boost exports. But the yuan gained more than 10% on the dollar in the year through May, and still exports surged.

In the past year in fact, even with the freefalling dollar, China’s trade surplus with the United States has grown from $12.6 billion to$14.3 billion, a gain of 13%. And the fact that exports are accelerating along with the value of the yuan will give China’s central bank some latitude in dealing with inflation.

‘Robust export growth could dispel domestic concerns that a stronger yuan is hurting exports too much,’ Gene Ma, head economist at China Economic Monitor, told BBC News.

The yuan has appreciated 5% against the dollar so far this year, making Chinese goods more expensive in foreign markets. At its current rate, the yuan will almost certainly improve on the mere 7% gain it posted against the dollar last year. And that will help China control inflation and shift from what its central bank called ‘heated’ growth to a more-sustainable economic expansion.

In fact, the effects of a stronger yuan already can be seen. Consumer inflation slowed to 7.7% in May from 8.5% the month prior, two government officials said Tuesday, citing statistics bureau data.

‘Inflation has peaked, at least temporarily,’ Ben Simpfendorfer, a currency strategist at Royal Bank of Scotland in Hong Kong, told Bloomberg. ‘Pork prices have stabilized to some extent. Vegetable prices certainly have.’

Food costs account for 34% of China’s consumer price index, and growth in agricultural prices slowed to 19.3% in May from 24.2% a month earlier, according to the Ministry of Agriculture.

Furthermore, the recent surge in oil prices probably won’t affect China’s consumer prices because of generous government subsidies. The government can afford to subsidize the price of fuel and is likely to continue to do so, Mark Williams, an economist at Capital Economics Ltd., said in a recent report.

‘Even if international oil prices remained at their current levels, the total net subsidy bill for the year would probably amount to less than half of one percent of GDP,’ Williams wrote in a June 5 report. ‘The costs of keeping prices down are still manageable given the strength of China’s state sector. Officials are wary of anything that could raise inflation expectations.’

And even though as producer prices climbed an astonishing 8.2% in May, inflation could still recede in the second half of the year – in part because figures will be compared with prices from last year when food prices soared uncontrollably.

‘The worst is behind us now,’ Paul Tang, an economist with the Bank of East Asia Ltd. (OTC ADR: BKEAY) in Hong Kong, told Bloomberg. ‘The question is more about at what pace the improvement is going to be realized in coming months.’

Profit watch’s Manraaj Singh sees huge potential for investment in China’s stock markets:

China’s CSI 300 Index, which tracks the leading companies on both of China’s stock markets, has fallen by 32 per from its October peak. That’s the biggest decline among the world’s 20 biggest equity markets. Hard luck if you were already invested in it, but excellent news if you’re looking to get in.

The slump has narrowed the CSI 200’s price-earnings gap with the Standard & Poor’s 500 Index to just 13 per cent at the end of last week. It was 139 per cent at its October peak. Companies in the CSI 300 now trade at an average price-earnings ratio of 26.4, down from a record of 52.8 in October. So, right now, they’re just slightly above the 23.4 ratio for the S&P 500. And China’s higher growth rates justify that.

But take a look at the Hang Seng China Enterprises Index. It measures the performance of 42 major Chinese companies that trade in Hong Kong. It has been cheaper than the S&P 500 since March and is now valued at 18.1 times profit. That puts it on a 12 per cent discount to the U.S. markets.

That brings me back to a point that I have been making here in this newsletter – The Asian markets have been massively oversold. A correction was in order, but the current sell-off has gone beyond what can be justified by the fundamentals.

The CSI 300 surged by 478 per cent over the last two years as China’s economy continued to race ahead and the government increased the supply of state-owned shares. But valuations clearly got well ahead of themselves. The rally fizzled this year on fears that prices had outstripped earnings prospects, that new share sales would overwhelm demand and that the highest interest rates in nine years will slow profit growth.

But those fears have been overblown. Chinese companies’ earnings actually grew by 5.5 per cent in the first three months of this year. Things haven’t gone so well in America. U.S. companies profits have dropped by 16 percent in the first quarter. China is clearly the better bet right now. Even after this years’ declines, the CSI 300 is still 322% higher than it was three years ago.

So, the correction in China provides a good opportunity to get in. A lot of the best companies are now trading on very attractive valuations. Even if we make allowance for overly optimistic growth forecasts for some of them, they still offer much better value than you are getting in the West right now.

How do we best play this? I like the country’s transport sector. The Chinese economy is still booming; and so is most of Asia…

I am tremendously bullish on Asian shipping companies at the moment. Right now, I see fantastic value in this sector, and nowhere better than in China.

But don’t despair. Because a trend that has long been talked about – economic decoupling – is finally starting to manifest itself as other world economies, particularly the so-called “BRIC” markets of Brazil, Russia, China and India, have continued to grow even as the U.S. economy has slowed. That means profit opportunities abound for U.S. investors, despite myriad messes on the home front that include a collapsed housing market, a mortgage crisis that turned into a five-alarm credit conflagration, and a plunging greenback that seems to have left its parachute on the airplane that it jumped from.

Some of the profit pathways to play:

• Investors can eschew the U.S. market completely, and pursue profits abroad.
• They can latch onto the U.S.-based members of the “Global Titans” club, companies with their headquarters in America that derive a hefty chunk of their profits from overseas markets.
• Or investors can ferret out U.S. investments that are either immune to some of this country’s current economic afflictions, or that are problem-plagued now, but a good bet for a turnaround later.

A Year to Forget?

Like a Dickens’ novel, 2007 was a definite “Best of Times/Worst of Times” combination for the U.S. economy. Volatility and crisis were the watchwords for much of the year. After key stock indices reached record highs in the middle of the year, the explosive emergence of the subprime mortgage debacle and related credit crunch pushed share prices into a nosedive that steepened as the year progressed.

With a 0.6% increase in gross domestic product (GDP) for the fourth quarter of 2007 and a first quarter that’s supposed to be flat at best, it’s clear that we’re not out of the woods, yet. Many fear that 2008 will find the United States in a recession. Other investors believe we have already experienced the first elements of a recessionary contraction.

“If I had to be bold, I’d say we began a recession in December,” Bill Gross, manager of the PIMCO Total Return Fund (PTTAX), told the Financial Times in a recent interview.

The Homeowner Blues

As 2007 progressed, many Americans experienced a growing despair as they watched their largest asset – the family home – experience a significant value decline. The United States is experiencing its worst housing recession in more than 15 years. And that domicile downturn is far from over. Consumers are being forced to watch as the housing slump siphons off the equity they’ve built up, even as it shaves the market value of their homes. Consumers with marginal credit who’d signed up for adjustable-rate loans have seen their mortgage rates “reset,” and then had to watch as their monthly mortgage payment ballooned to the point that they could no longer afford those payments.

For many, unfortunately, refinancing hasn’t been an option. The vanishing homeowners’ equity made such deals unfavorable to lenders. And with the burgeoning credit crisis that quickly became global in nature, banks and mortgage firms have slashed the available amount of refinancing loans that homeowners needed to escape their soaring mortgage payments.

Soon, the banks that had made the questionable calls on subprime loans were in trouble, too. With the housing market cooling, the homeowners who couldn’t refinance also discovered that they couldn’t sell. Homeowner defaults – loans that are 30 days or more past due – soared and started a firestorm that has swept through the global financial-services sector, singing such stalwarts as Citigroup Inc. (C), Fannie Mae (FNM), UBS AG (UBS), and others.

“It will take most of the year to work out of the housing slowdown. Currently, the inventory of unsold homes is at an eight to nine-month level. We have to get this down to a more normal level of four to five months. In order to get to this level, housing starts will remain low,” Dr. Robert Sweet, an economist at MTB Investment Advisors, the investment-advisory subsidiary of M&T Bank Corp. (MTB), said in an interview with Money Morning.

And we might be getting closer to the bottom. In fact, existing home sales rose in February, the first such increase in the past seven months. But it’s probably too soon to get excited about a full housing recovery.

“It looks like this may be a temporary pause,” Nigel Gault, chief U.S. economist at Global Insight Inc. in Lexington, Mass., told Bloomberg News after the existing homes sales report was released. “The price declines have helped, and people are still getting financing, though not on the good terms they could before.”

“We’re still a long way from a recovery in housing,” Gault said.

The Fed to the Rescue?

U.S. Federal Reserve policymakers cut the benchmark interest rate by less-than-expected three-quarters of a percentage point at their last meeting, a move that was designed to energize a badly flagging economy without causing inflation to spike or exacerbating the greenback’s decline.

When central bank policymakers reduced the key Federal Funds rate from 3% to 2.25% on March 18, it was the sixth time in seven months the closely watched benchmark had been reduced. Many analysts had been expecting a reduction of a percentage point – or even more – as such recent events as the near-collapse and subsequent Fed-led bailout of U.S. investment bank The Bear Stearns Cos. Inc. (BSC) stoked fears that the U.S. financial system was ready to seize up.

The policymaking Federal Open Market Committee (FOMC) has now cut the Fed Funds rate six times and slashed the Discount Rate for direct loans to banks eight times since August, when the subprime mortgage market collapsed and created a global credit crisis.

While the FOMC made it clear that inflation has grown as a concern, it still says that economic worries remain the biggest problem and emphasized that it was ready to act again if need be.

“Today’s policy action, combined with those taken earlier, including measures to bolster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity,” the FOMC said in its March 18th statement. “However, downside risks to growth remain. The committee will act in a timely manner as need to promote sustainable economic growth and price stability.”

Of course, financial companies have assets. But they’re not tangible things. You can throw a rock at your neighbour’s window, and it’ll shatter. If you threaten to throw a mortgage-backed asset at your neighbour’s window, he’ll probably run shrieking out his own front door all the same. But the window won’t break. Securitised assets can’t be thrown, no matter how much misery they’ve caused.

Real tangible assets are in a bull market at the moment. A non-imaginary one. The values of commodities can be identified in real markets. There are real people buying these things, and transporting them to real countries in real ships. They crush them and cook them with real machinery, then sell the refined product to a real end-use.

We may very well see a bubble develop in the commodities boom soon. Anywhere where there’s a good opportunity, greed and opportunism follow. But the real nature of this boom is what sets it apart from booms in technological speculation or financial earnings.

Now here’s the important part…what happens now that the mining sector is the undisputed leader of the market?

Could this be a symptom of the much-maligned “decoupling” theory?

Commentators slaughtered the idea last year. The Aussie market fell just as fast as the US. Indeed, global equity markets fell in unison. But that was when the Aussie market had finance as its lifeblood.

Since then, trade with other countries has increased. Our five top exports are all resource offerings. Iron…two types of coal…oil…and wheat. There are no securitised assets or government debt on that list. Just useful things.

A true decoupling can’t happen yet. That would, among other items, require a major overhaul of the international currency system. But a-mini decoupling of sorts is already happening in the Aussie economy. Every time we export more iron to China, we have a little less to do with the US economy.

Chinese Wheat Production Hit by Disease

China’s National Bureau of Statistics says the country’s largest wheat-producing province won’t be breaking any records this year. Henan Province is facing disease, not to mention rising costs from oil and fertiliser booms.

Woe, woe, woe…

It’s a disconcerting fact that agricultural production today is an oil-based business. We turn natural resources into food. Petrol fuels the massive machinery that mass-production farming requires. Phosphate, potassium and nitrogen make up the chemical fertiliser that stimulates extra returns on crops.

Rising prices wouldn’t so much of a problem if Chinese farmers could make up the difference with a good year. But pests are making the situation harder. ‘Sharp eyeshot disease’ is expected to take its toll on Chinese wheat fields this year.

As we said earlier, wheat is one of Australia’s top exports. If China can’t get enough wheat, it’ll look to us. Now that AWB (ASX:AWB) has lost its grip on the exporting trade, a few second-tier wheat players may be worth a look…

Gold in a Good Place for Buying

If money’s moving out of stocks, where will it go?

It might be time to take another look at the ultimate alternative, gold. It hasn’t made a major move since it came back from US$1000. Gold costs US$920 this morning. Our hunch is that that’ll change in the next month or so.

Al Robinson
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Source: Chinese Wheat Production Hit by Disease

“This place is one big construction site,” Fitz-Gerald said. “You cannot turn around without finding scaffolding, piles of materials, construction equipment and the like [no matter where you look] here.”

With the U.S. economy suffering its worst downturn in years, and China’s stocks down more than 40% in the past six months, the bustle of construction-related activity in this Asian giant seems incongruous – if not downright contradictory.

Surprisingly, it’s neither. This divergence between China’s ailing stock market and its still-spunky economy is an early manifestation of “economic decoupling” – an emerging trend being fueled by the globalization of worldwide markets.

In fact, China’s ability to maintain its frenetic growth rate of nearly 11% per annum while the U.S. market could well be mired in a recession is yet another example of economic decoupling, says Fitz-Gerald, the investment director for Money Morning who is currently leading a group of investors on a tour of Mainland China.

“Economic decoupling will continue and is accelerating with each passing day,” Fitz-Gerald said in an e-mail interview from China.

But the main point to remember is that economic strength is a function of consumer power – which China has plenty of, with more still to come – whereas stock markets are a function of expectations.

And the amount of new investors in and outside of China blew expectations too high for companies to deliver, especially in the face of a U.S. slowdown.

“Economic strength and stock markets do not have to move simultaneously. In fact, history suggests they don’t. Cycles nearly always reflect underlying economic movement prior to financial markets separating,” Fitz-Gerald said.

A Tough Deal

Not everyone agrees with Fitz-Gerald’s assessment. The broadest of the three key U.S. stock indices – the Standard & Poor’s 500 Index – is down 8.38% in the past six months, although it was down nearly double that before a recent rebound. And the U.S. economy is near – if not actually in – a recession.

Until recently, the U.S. economy was such a key element of the global market that a downturn here made it a near-virtual-certainty that overseas economies would sour and spiral downward – hence the Wall Street adage: “When the U.S. economy sneezes, the rest of the world catches a cold.”

Perhaps no longer. Rich in both commodities and cash, China’s economy continues to advance. But here’s the part that makes decoupling tough to understand: Although the Chinese economy is still growing at a double-digit rate, its benchmark Shanghai Composite Index is down a painful 40.3% in the past six months.

And some of the country’s all-star companies have really taken it on the chin. The past six months, for instance:

• Aluminum Corp. of China Ltd. (ACH) is down 40.65%.
• iShares FTSE/Xinhua China 25 Index ETF (FXI) is down 22.34%.
• PetroChina Co. Ltd. (PTR) is down 40.44%.
• And China Life Insurance Co. Ltd. (LFC) is down 33.75%.

Skeptics of decoupling will argue that China’s index is tanking in lockstep with the U.S. economy. However, Fitz-Gerald, who lives in and around Asia, sees a different story both in the numbers and on the ground.

So what gives?

“Most of [the critics of decoupling] are Anglos sitting in the heart of New York City, never having visited and seen this first hand,” Fitz-Gerald said. “Economic progress here is unstoppable and market slide is temporary.” 

The real answer is that different forces are influencing Chinese stocks and the Chinese economy, meaning the two aren’t always as interlocked as people would like to think.

For a long time, most China stocks were off-limits to foreigners, and even domestic investors faced restrictions on where they could put their cash. As an increasing number of China-based companies went public and made their shares available to both domestic and foreign investors, cash poured into those firms, running their shares up much higher than the company’s underlying value really warranted.

“There is so much capital chasing them that it’s natural they’re going to move,” Fitz-Gerald said.

Granted, some investors who knew when to cash in and pull out made quick fortunes.

But many first-time investors (or first-time China investors) bought Chinese stocks blindly, lost a ton of money, and are now scratching their heads wondering why investment analysts keep talking about China’s vast investment potential.

The major culprits that dragged down China’s indices are stock market linkages between the United States and foreign markets – meaning that currency devaluations and slowing foreign economies (such as China’s major trading partner, the United States) pinched the profits of some Chinese companies – but nowhere near enough to cause a downturn there.

Plus, unlike past emerging-market downturns, there hasn’t been massive “capital flight,” with foreigners taking their money and heading for the safety of their banks at home. China has too much long-term profit potential for foreign investors to give up now.

Besides, even if they did, China has record foreign reserves of $1.68 trillion – more than enough to weather a rainy day in the economy there.

On top of sightseeing, shopping, food, and hospitality well beyond the standard tourist fare, Fitz-Gerald is leading a tour of one or more of China’s stock exchanges. [Fitz-Gerald is also the editor of the New China Trader, an investment newsletter dedicated solely to finding value and profits in China’s red-hot economy].

And although it’s difficult for investors to navigate through the volatile markets, the long-term payoff is worth the pain.

The bottom line is that China is on track for 10% to 12% growth this year – and that’s after China’s government has taken steps to slow the country’s economy down.

“Investors who abandon China now will live to regret their decision,” he said. “Even if the U.S. economy skids into a recession, China will continue to grow for decades to come. And that’s after nearly 30 years of double-digit growth that country has already logged into the history books.

A US energy economist has a neat explanation as to why this is happening – and it fits exactly with my view of the world. It’s all about population growth leading to energy shortages – and he believes it’s hitting oil-producing nations hard.

Writing in the Financial Times, Ohio Northern University Energy Economist AF Alhajji, said that Opec’s vanishing excess capacity was now keeping the oil price above $100. He argued that Gulf States’ power crises were now a primary driver of the oil price.

Excess capacity too

Alhajji argued that when considering total oil stocks, you must include inventories in industrial nations PLUS excess capacity in producer states. We all seem to focus on US oil inventories – but we should be looking at capacity in producing nations too.

Despite rising inventories; vanishing capacity in Gulf nations makes total global oil stocks so small that this has been the main driver keeping the oil price above $100, he argued.

So, based on this analysis, when we are considering global oil stocks, oil EXPORTS from these countries are the most important factor – NOT total oil production.

Rising living standards, soaring populations and urbanisation is increasing demand in oil-rich nations. They are using their own oil to supply their soaring energy needs. This would also explain why Opec has been reluctant to increase production… it simply can’t because of its own power shortages.

In March, the Middle East Economic Digest warned of an imminent power and water crisis across the Gulf. It said there was a serious supply and demand imbalance caused by a lack of infrastructure investment earlier in the decade.

The GCC is currently building a Gulf power grid that will connect the six member states, paving the way for a regional electricity market. The grid will not come online until 2009, however.

So, a temporary change in the dollar’s fortunes has revealed that fundamentals are taking over as the main driver. Cheap oil really has gone forever.
Regards

For Garry Writes