Remember a few years back when the term decoupling was all the rage? Emerging markets and Europe were supposedly going to decouple from the US economy’s troubles and continue growing while the US suffered through its real estate bubble collapse. Well that didn’t work out so well with most every market in the world eventually succumbing to the undertow of the US troubles. China did enact an enormous stimulus package that turned around their economy and most of the emerging markets – at least for a while – but there was no decoupling to speak of. Emerging markets and Europe suffered right along with the US.

Now, the credit bubble created by that Chinese stimulus plan is deflating and the rest of the world economy outside the US with it. Or at least it appears that is what is happening. Chinese economic statistics aren’t exactly revealing but we do know that their money markets experienced some pretty severe pain the last few weeks. There has been talk that the spike in interbank lending rates was engineered by the Chinese central bank to try and rein in credit growth but whatever the cause, it looks a lot like what happened here in the US right before the Lehman failure and the acute phase of the 2008 crisis. The Chinese “stimulus” was fueled by credit growth that amounted to roughly 30% of GDP since 2008 to fund all manner of public and private “investment”. Call it overinvestment or malinvestment or pyramid building as I did, but the fact is that the Chinese economy has been completely dependent on credit and government directed investment for the last 5 years and it is coming to an end.

There is a knock-on effect in the countries that have drafted in the wake of the Chinese growth, artificial though it may have been. All the countries that have boomed by supplying raw materials to China are now seeing the downside to that dependence. I’ve written about Brazil’s recent difficulties – which don’t seem to be improving – but other countries are starting to feel the pain as well. Australia’s dollar has been falling almost as rapidly as the Brazilian Real, down almost 14% just since April. The Canadian dollar is down over 10% from its high. Even Chile, the best run economy in Latin America, has seen its Peso fall over 7%, tracking copper prices that are so important to that economy.

In Europe the pain isn’t as direct or dire yet, but 7% of Germany’s exports go to China primarily in the form of capital goods. As foreign direct investment in China slows – it fell last year and is only partially recovering this year – demand for those capital goods will likely fall. In addition, estimates are that China’s capacity utilization rate is only running at 55-60% (versus 75.8% in the US) so more investment to expand that capacity further may not be seen as the best use of Chinese capital at this point. I suspect that the pressure on the German economy played a role in Mario Draghi’s obvious and successful attempt to talk down the Euro this last week. The German economy is about the only thing still growing in Europe other than opposition to “austerity” and a slowing China coupled with a weaker Japanese Yen are not good news for German exports.

China’s experiment with uber-Keynesianism is failing. The standard explanation from Keynesians when stimulus doesn’t work as advertised – it wasn’t big enough – would not seem to apply to China where investment reached such dizzying heights. The other explanation, that it wasn’t targeted at infrastructure, is also wrong when it comes to China. Infrastructure spending as a percent of GDP in China is much higher than the US and they approved another $150 billion for this year. The fact is that the Chinese have followed the standard Keynesian prescription to the letter and now after a 5 year spending binge they are faced with a situation very similar to what the US faced in 2008. In the US the overinvestment was in real estate  but in China it reaches to all corners of the economy.

So, the question is whether the US can weather this Chinese led storm and decouple from the rest of the global economy. So far, so good, one might say with the US economy apparently well enough for the Fed to consider tapering their endless monetary stimulus. The US dollar is rising as all the capital that had found its way to emerging markets desperately looks for a more hospitable home. Interest rates are up on the back of rising growth expectations and while that might seem negative at first, it might also encourage banks to lend more with a steeper yield curve. Real estate is recovering and the fear of higher rates might also get some potential buyers off the fence. Auto sales are running at nearly 16 million. The economy continues to add jobs although the unemployment rate is a still too high 7.6% and the quality of jobs leaves a lot to be desired.

So, it seems like so far the US economy is continuing to chug along at the sub par 2% rate it has for the last two years and while that isn’t great, it doesn’t seem to be getting worse and if you squint you can even imagine better growth in the near future. At Alhambra we have a more dour view of US growth prospects but let’s put that aside for a minute and assume that the things driving US growth – primarily real estate and auto at this point – will continue to do so. Besides, economic growth is not strongly correlated with stock markets except over the very long term anyway. And as I stress to our team all the time, the economy is not the market and the market is not the economy. We are interested in whether the US stock market can decouple from the rest of the world.

When it comes to stocks, the US market has so far resisted the downtrend of basically the rest of the world. There are exceptions but when I start looking at global stock markets I find a lot of established downtrends. The list of country ETFs below their 200 day moving averages (which is a fairly well agreed on dividing line for up and down trends) is long: Australia, Austria, Brazil, Canada, Chile, China, Colombia, Greece, Hong Kong, India, Indonesia, Italy, Mexico, Peru, Poland, Russia, Singapore, South Africa, South Korea, Spain, Thailand, Turkey and Vietnam (that isn’t an exhaustive list obviously). The US, parts of Europe and Japan are about the only places you find markets that are still above that dividing line and bucking the obvious global trend.

Stocks follow earnings and that is where US companies may have a problem. Earnings season starts soon and we have already seen a large number of negative pre-announcements – a record in fact. The companies of the S&P 500 get almost 50% of their profits from outside the US and the vast majority of their growth in earnings has come from, you guessed it, emerging markets. With the US dollar rising, especially against those same emerging market currencies, keeping profits rising in dollar terms will be increasingly difficult. Even if sales can keep rising in local currency terms – and that seems unlikely given their slowing growth – translating them back to US dollars may not be a pleasant experience.

The idea that US stocks and the US economy can decouple from the rest of the world isn’t as ridiculous as the reverse. We are the 400 pound gorilla of the global economy still and what happens here is much more important than what happens elsewhere. But unless we get a surge of domestic growth to offset the drop in growth outside the US, earnings seem likely to take a hit. Stocks are not cheap by most measures and there is a whiff of speculative activity with micro cap stocks making new highs last week. And stocks are certainly not priced for falling earnings. If anything, stocks are priced based on a surge in earnings predicted by analysts for later this year.

China is attempting something that has never been successfully done before – deflating a credit bubble without collapsing their economy. I won’t say it is impossible but the odds are definitely long and even if they do it successfully there will be effects outside China. We’ll find out over the next month as earnings are released how much of an impact the global slowdown is having on US companies so far. I suspect it won’t be pretty and if China’s bubble management skills are no better than ours, it could get a lot worse. We live in a global economy and decoupling really isn’t an option.

Click here to sign up for our free weekly e-newsletter.

“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.