At a loss? Where to look for growth

Will the superior economic performance of developing economies such as China and Brazil translate into superior stock market returns over the next 12 months? Or, as the United States and the European Union slide toward slow to no growth, will the dismal performance of the world's developed economies drag all boats to the bottom?

In other words, will emerging stock markets decouple from developed stock markets in the last part of 2011 and in 2012? I think that's the most important question facing stock investors right now.

What's decoupling?

Decoupling is when a stock market dances to its own tune rather than moving in lock step with other markets or with the global market as a whole. Decoupling can lead to foreign markets that either outperform or underperform the U.S. by extreme amounts.

We've been through a good example of underperformance of emerging markets in the last part of 2010 -- but it didn't quite meet the standard of real decoupling.

In the fourth quarter of 2010, the Standard & Poor's 500 Index ($INX)gained 10.8%. The Brazilian stock market, as tracked by the iShares MSCI Brazil Index (EWZ)gained just 4%. Then, from Dec. 31, 2010, to its peak on April 29, 2011, the S&P 500 climbed to 1,364 from 1,258. That's a gain of 8.4%. From December 31 to April 29 the MSCI Brazil Index Fund went from $76.23 to $76.55. That's a gain of 0.4%.

Clearly Brazil underperformed the U.S. But even then, the two markets moved in the same direction -- even if just barely.

Pure decoupling is different -- and rarer. Let's look at what happened in 2007. In the fourth quarter that year, the S&P 500 went down by 3.6% while the Brazil Index Fund went up by 11.4%. For the year, the S&P finished ahead a paltry 4.9% and the Brazil Index Fund was up 74.8%.

Could we see that kind of decoupling (or even just extreme outperformance) in the remainder of 2011 and in 2012? The economic growth trends give decoupling a good chance.

Why decoupling is ahead

According to leaked information, the International Monetary Fund will cut its forecasts for U.S. and eurozone growth when it releases its next report on global growth Sept. 20.

For the United States, the forecast growth rate for 2011 will go to 1.6% from a forecast of 2.5% just two months ago. For 2012, the forecast will call for 2% growth, down from 2.7%. For the eurozone, the drop will mean a forecast of 1.9% growth in 2011 (down from 2.0%) and 1.4% growth in 2012 (down from 1.7%).

In contrast, the IMF forecasts the global economy will grow by 4.2% in 2011 (down from a prior forecast of 4.3%) and by 4.3% in 2012 (down from a forecast of 4.5%).

That's a big enough difference -- roughly two times more growth for the global economy as a whole than for these two big developed economies.

But the gap widens if you look at the economies of China and Brazil separate from those of the smaller nations.

For Brazil, the central bank's most recent survey of economists showed a consensus forecast of 3.67% growth for 2011 and 3.84% in 2012. The government of President Dilma Rousseff is projecting 5% growth for 2012. (More later on who might be right.)

For China, growth estimates have been falling as the global economy slows, but the consensus for 2011 still hovers just below 9% (Deutsche Bank, for example, forecasts 8.9%, and UBS comes in with 9%). For 2012, consensus growth is at 8.3% or so.

Economic growth rates alone don't determine stock prices. Otherwise Chinese and Brazilian stocks would have outperformed the U.S. and European equity markets in the first half of 2011.

Watch the direction

Expectations for the direction of economic growth rates are far more important, I'd argue. In the first months of 2011, for example, the belief that the U.S. and eurozone economies (those of Germany and France, actually), were growing at better than expected, if still low, rates, buoyed stocks in those markets. Fears that China and Brazil were slowing -- even though the projected slowdown was to a growth rate two or three times higher than in the developed economies -- weighed heavily on stocks in those markets.

Also important, I'd say, is uncertainty over the direction and ultimate destination of economic growth rates. China's financial markets have performed poorly this year, falling 11.2% as of Sept. 7 and 17.6% from their April 13 high. They've performed even worse since they peaked on Nov. 8, 2010, falling 27.7% as of Sept. 7.

A good part of that decline has been because of uncertainty over how much growth Beijing's fight against inflation would take out of the economy and fears that a long program of interest-rate increases and additions to bank reserve requirements would send the economy crashing to a hard landing.

So where do China and Brazil stand on those two scales?

China looks like it is near a peak in inflation -- 6.5% in July -- with economists calling for a dip to 6.1% for August in data to be released on Friday. That wouldn't put an immediate end to China's round of higher interest rates and added bank reserve requirements, but it would tell financial markets that the end of this cycle is near. Investors could start to take their worries about tighter monetary policies leading to an unexpected drop in growth off the table.