In that ad hoc comment, we wrote: “The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption d) in the US, the subsidy has by and large been captured by individual consumers e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed f) we see little reason why, in the near future, the subsidy should be removed but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world) while h) Europe could go through a debt crisis (far more problematic).”

We went on and wrote: “Last week, and against most observers’ expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country’s inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank’s apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.

This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.

One could argue that a change in monetary policy in Asia could end up being a “triple whammy” for Western economies. It would mean that:

• Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
• Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
• As Asian exchange rates start to move higher, Asia’s private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.

Finally, we concluded the paper by saying: As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about “excess leverage” in the system, or the threat of a “private equity bubble”. We also do not fear an “economic meltdown” or a brutal end to the “Yen carry-trade” (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities — a hedge against rising real rates — makes sense to us – as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.

Nine months after that paper, we have indeed just gone through a period of a) rapidly rising food prices which have led to b) faster inflation rates across Asia, which have triggered c) a change in Asian monetary policy, notably a willingness to let the currencies appreciate faster than they have in the past. And if Asian central banks are now finally allowing their currencies to rise, then one thing is sure: Asian central banks will no longer need to print large amounts of their own currencies and accumulate US$ and Euros. They will thus also no longer need to buy US Treasuries and European bonds to the extent that they have.

Is it a co-incidence that, as Asia starts to allow its currencies to rise, US mortgages have been hitting the wall and spreads amongst European sovereigns have started to widen? The subsidy that Asian central banks have been giving to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.

Indeed, for the past five years, spreads of Italian ten-year government bonds to German bonds have hovered between 15bp and 25bp. But recently, spreads have started to break out on the upside.

And, of course, Italy is not alone. All across Europe, we have seen a widening of spreads between the “stronger” signatures (Germany, Holland, Austria, Finland, Ireland) and the “weaker” signatures (Portugal, Italy, Greece, Spain, Belgium, France) including those of Eastern Europe (Latvia, Romania, Hungary, Poland…).

“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.