The Real Decoupling in Emerging Markets

Have emerging markets really decoupled from the U.S.?

Jonathan Garner, head of Global Emerging Markets Equity Strategy at Morgan Stanley(MS Quote - Cramer on MS - Stock Picks), gave some thoughts on why emerging markets could decouple in the face of a U.S.-led global slowdown, speaking Tuesday on "Asia Squawk Box" on CNBC World.

Garner noted that emerging markets comprise 30% of the world economy and provide 60% of the world's growth. The relationship the U.S. now has with emerging markets (that the U.S. needs them to buy Treasuries) has essentially changed the balance of power favoring the emerging markets.

Garner says the U.S. and Western Europe need the help -- not the emerging markets -- which is a 180-degree turnaround from the crises of 1997 and 1998.

He further notes that demand for oil will remain high in the BRICs (save for Brazil, which has a more evolved ethanol program) as car sales continue to go up at a much faster rate than in the U.S. That's also a plus for the entire commodity theme, which further benefits emerging markets.

I can't argue with any of the points he makes in building his case, but I don't agree with his conclusion.

Emerging markets are an important part of any diversified portfolio and have contributed mightily to investor's returns over the last few years.

Looking out over the long term, I believe, they will continue to offer meaningful outperformance. I recently increased exposure for clients from about 5% up to 7% with a Chilean bank, but the notion that stock prices will be immune if the U.S. does continue to deteriorate from here is a bad bet.

The general case for emerging markets relies on the ascendancy of the middle class, modernizing infrastructure, faster growth rates and higher prices for the commodities that these countries provide. These catalysts, to Mr. Garner's point, are not going to go away -- but there is nothing to say that stock prices won't go down nonetheless.

Throughout this stock market cycle we have seen that during corrections (like second-quarter 2006, first-quarter 2007, summer 2007 and Jan. 2008), correlations of all asset classes go up. Emerging markets have gone down just as much, if not more, during all of these episodes.

For example in the second quarter of 2006, when the S&P fell 7.6%, iShares MSCI Emerging Market Index Fund(EEM Quote - Cramer on EEM - Stock Picks) fell 25%. This repeats over and over and expecting that "this time will be different" is a difficult bet to win.

I believe the way to incorporate Garner's comments into your portfolio is that there is a fundamental decoupling -- not a stock-market decoupling. The money spent on things like infrastructure and modernization will not be altered in a significant way, which has nothing to do with stock prices.

If the fundamental story stays intact, which I believe it will, it sets the stage for stock prices turning up sooner in emerging markets than in the U.S., which is a different concept than being immune from the selloff. During the last bear market there were several examples of this, including Malaysia and Chile (charted below).

Malaysia (as measured by iShares MSCI Malaysia(EWM Quote - Cramer on EWM - Stock Picks)) bottomed out 18 months before the S&P 500. Chile (charted in black) had an up year in 2001 and although it was down a lot in 2002 it offered protection for much of the decline.

Another example, although not an emerging market, is Australia, which hit its bottom a year before the U.S. market.

There are plenty of reasons to own and be optimistic about emerging markets, but emotionally banking on a price decoupling is bound to lead to disappointment. Allocating too much to the space is likely to lead to a more volatile ride through what appears to be a bear market.

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