"It's a zero sum game, after all"

Any shards of residual decoupling theories have been laid to rest by the draining more than $2 billion out of emerging-market funds in each of the past two weeks. The surprise, perhaps, is that emerging markets have not performed even more poorly; the MSCI emerging-markets index’s 12.4% decline so far this year is only a little worse than the return of the global market. Amongst the central bankers of the emerging markets, RBI has been the latest, raising interest rates for the second time in a month on June 24th, even though higher rates will mean slower economic growth. But central banks will be damned either way. Any country that fails to raise rates enough to keep inflation under control will scare away investors. South Africa and Vietnam have failed to keep the lid on prices and have been duly punished with a depreciating currency.

So how did the decoupling theory fail and emerging markets suddenly lose their charm?

One look at the MSCI index – that foreign investors’ favorite benchmark – gives some idea. Emerging markets benefit from the heavy weighting of commodity-related stocks in the index (more than a third, according to Merrill Lynch). The overall market is unlikely to plummet when mining and energy stocks are holding up so well. The corollary, however, is that emerging markets will be vulnerable if commodity prices tumble. Earlier in this decade, conditions were ideal for emerging markets, because commodity prices were going up and local interest rates were going down. Now interest rates are rising and there is the risk that commodity prices could at some point correct.

It’s a zero sum game after all.

Where US foreign policy slacks, Rest of the world gains

I have always suspected that globalization will give Americans a brutal awakening, present them a vicious façade of inside-out economic and political reality and a fair sense of perception from outside – that will clue them in on how deviant are they from the mean and how unsustainable is their global leadership positioning.

Parag Khanna – the foreign policy strategist, Obama campaign - excerpts

“Where the Pentagon has missile programs, the European Commission has reform programs. They’ve got their boots on the ground in the form of well-heeled diplomats who are in the ministries of every country from the Baltics into the South Balkans and Albania, all the way out to Azerbaijan. They are actually inside the ministries, fixing these countries basically from the inside out. And the reason these countries become members of the European Union, and you wake up one morning and there’s yet another member and you didn’t hear a shot fired, is because that works. Europe works.

Let me give you two more quick examples, because they’re the two most important ones in the whole world: Russia and China. America talks about missile defence, [which has made] Russia feel threatened and therefore block NATO expansion. Has Russia ever been able to block EU expansion? No, because the EU isn’t doing anything threatening.”

That sure should be real enough to shatter American strategic smugness ...

"When a big tree falls....

…the earth shakes." So if you are quake-o-phobic, prop it up. Never let it fall. That’s what regulators did with MBIA, the big bond insurance company, reneged on a promise to shore up a crucial unit with $900 million in capital.

MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.

"But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.

In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit." [Hat tip : NYT]

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Focus on direction of inflation, not the rate

Alright. Inflation is high. So what do you do? Dump stocks and run?

“Don’t!” - Says Paul J Lim, in this NYT article.

Quoting some expert arguments, he concedes –

a) inflation devalues corporate earnings that drive stock prices. But the mere presence of inflation also suggests that many companies are successfully passing along price increases to customers. The returns from stocks will be far better than bonds. In the 23 calendar years between 1926 and 2007 when inflation measured more than 4 percent, stocks returned 6.9 percent on average, versus just 2.8 percent for long-term government bonds.

b) Analysis reveal during inflationary periods, most sectors outperform and are a sure long term hedge against inflation.

c) Observe the direction of inflation. High rate of inflation that heads southwards is a far better time to be in stocks than low rates of inflation that is heading northwards. In periods when the inflation rate fell, stocks soared by an average of nearly 10 percent.

d) There’s a perfect inverse relationship between core inflation and stock market valuations. Since 1960, whenever core inflation has hovered between 2 and 3 percent, the average P/E ratio of the S.& P. 500 has been 19.7, based on trailing 12-month earnings. But when core inflation jumps to between 4 and 5 percent, the average P/E falls to 14.8

So now you know what to do. Don’t dump your stocks. Just keep’em and you’ll be better off. (Because if you sell, I am not liquid enough to buy :-)
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