Discussions of decoupling between emerging and developed markets continue. As a balance sheet recession burdens much of the developed world the emerging market has experienced an economic resurgence in recent years. But Kevin Gaynor and Bob Janjuah of Nomura are not believers in the decoupling story. In fact, they believe their interdependence creates even greater risk for the global economy. According to the Nomura analysts they see a melt-up followed by a melt-down OR a slow-down:
“Hopefully it is now clearer that the two regions are as intimately dependent on each other as ever, even if we only take a global view of demand growth. Accelerating DM domestic demand combined with strong EM domestic demand would be a recipe for bottlenecks and inflation pressures. The potential in that environment for a blow-out period of growth is real, in our view. Perhaps that is where the global economy was headed before the rude interruption of the financial crisis. But recall that heady period did result in concerns about commodity inflation. There are limits to growth in that regard.
Decelerating EM domestic demand would put growth at risk for those sectors and economies most attuned to it; the commodity group and capital goods exporters. Jobs would likely be lost and profits fall. To the extent that this has been a key support for the recovery to date the aggregate picture would look rather poor with consequent implications for sovereign fiscal considerations, not least in Europe. In the absence of further policy stimulus it is not easy to see DM domestic demand being able to unilaterally and quickly step in to cover the resulting global demand gap. In a sense then slowing EM growth would lead inexorably to a period, at least, of slowing DM growth. Whether DM can shrug it off quickly is an open question for now.
In a similar vein accelerating DM domestic demand would lead to an accelerating impulse for the EM region. If policy remained unchanged in that region overheating would be that much more likely, risking a subsequent hard landing as the domestic investment boom crunches. So the accelerating DM story would inexorably lead to accelerating EM too, all else being equal.
Taking this simple trade-off view of the world suggests we are in a rather poised moment for the global business cycle. In any event substantial regional shifts in growth would have to happen in a coordinated and beautifully choreographed manner for there to be no disruption to aggregate growth.
As a result Bob and I are left feeling more nervous than before. The four sectors ultimately end up as two – melt up or slowdown. We think we are about to experience either a melt-up followed by melt-down or a slowdown. Neither is the central case message we are hearing from our customers, rather the working assumption appears to be that both regions can operate independently of each other; that an EM soft landing may happen but will be fully offset by accelerating DM demand. No doubt that rotation in marginal demand is the most likely medium-term outcome, but any missteps would return a slowdown in global aggregate demand.
As such, we think the shift from EM risk into DM assets makes sense. The more risky positioning is on rates markets and DM risk. Both of us think rates are becoming attractive on a valuation basis, and that protection is looking cheap against risk assets.The saddle path solution to normalising global demand to us seems a very narrow one, and so the wings of the risk distribution should be more expensive rather than less.”