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China Sinks: De-coupling Theory Not Holding Up

Although strong in the second half of 2007, Asian funds re-couple with their developed market counterparts in 2008.

Ash Kumar, 18 February, 2008 | 11:21AM
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No matter how compelled you feel but it's not time yet to throw away the adage - When Uncle Sam sneezes, the rest of the world catches cold.

The latest fund performance data offers more evidence that de-coupling, a favourite buzz word of 2007, is far from a fait accompli. Although resilient during the second half of last year, funds in the Morningstar Asia Pacific ex Japan, India and China Equity

a> categories are caving in this year as evidence of a recession in the US mounts.

Two Different Viewpoints
 The proponents of the de-coupling theory believe that countries such as India and China will largely remain unaffected even if the US economy slowed appreciably, as intra-regional trade and the strong internal demand push will keep them afloat. The theory also suggest that Indian and Chinese consumers combined could make up for the shortfall resulting from a weak US consumer, implying the world is less dependent on the US now than it has ever been in the past.

However, there are some very pertinent questions about the de-coupling argument. How can India and China combined fill the void created by a weak US consumer if the latter consumed - based on Morgan Stanley Asia data - $9.5trillion worth of goods and services in 2007 while the former gulped just $1.65 trillion? Furthermore, exports accounted for nearly 46 per cent of the developing Asia GDP in 2007 - with the US being a major trading partner for most of the countries in the region. Even if exports to China from within Asia have increased, the final destination for a lot of these goods is ultimately the U.S. Last but not the least, if Asia has benefitted from globalization over the past two decades then how is it possible for it to now remain immune to global weakness?

De-coupling or Re-coupling?
 The performance of Asian stock markets vis-à-vis the US, European and UK markets unfortunately suggests that the US contagion has reached the Asian shores, pouring cold water over the de-coupling theory. In January, China was the worst performing market in the world, down 21% and India amongst the worst performers, losing 14.5% in a month. While the S&P500 index was also in the red, it was down just 5.8%. This is in stark contrast to the figures for the third and fourth quarter of last year when Indian and Chinese markets led their US counterpart by a significant margin.

Reflecting the markets, funds investing in the region (Morningstar China Equity, Morningstar India Equity and Morningstar Asia Pacific ex Japan Equity categories) have followed suit. They looked resilient in the second half of 2007 despite the US sub-prime mortgage crisis erupting as the credit crunch spread across Europe and the UK. In fact, the China and India funds available for sale in the UK posted high double-digit returns in the second half of last year. But, the tables finally turned in January when the three Asian funds' categories recorded double-digit falls in comparison with the US funds' single-digit decline, raising further doubts about de-coupling.

Too Much of Anything Is Not Good
 But, what does all mean for investors? Some have already begun voting with their feet, as latest IMA figures show an estimated £250m flowed out of the IMA Asia Pacific ex Japan and IMA Global Emerging Market sector funds in just two months - November and December 2007. It goes without saying that 2008 will be a difficult year for investors and advisers. If the markets which some believed would de-couple, that is remain strong, despite appreciable weakness in the US - and Europe and the UK - have begun to cave in then where do investors park their money? How do they protect their portfolio from heightened volatility?

The answer lies in remaining adequately diversified - both in terms of geographical and asset class allocation. Avoid excessive exposure to emerging markets, particularly India and China. Even though we don't question their long-term growth potential, if you have chased performance up or even failed to trim back your winners over the past few years, you may well be over-exposed at this juncture. Given that Global Emerging Market funds also invest heavily in the two Asian behemoths, it is crucial investors understand the true extent of their India and China exposure (you can use Morningstar.co.uk's Instant X-Ray to check this quite easily). The de-coupling theory, it seems, is unlikely to help you balance out your portfolio.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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