Akash Prakash: Decoupling tested

The meldown will pose a tough test to the decoupling thesis.

The carnage in share prices witnessed over the last couple of days bears testimony to growing risk aversion and fear. Global markets are off to one of their worst starts ever with all major markets down high double digits since the beginning of the year. Surprisingly this downward move has been led by the emerging market asset class, which, at close to 20 per cent down, is now fast approaching bear market territory (the definition of a bear market is usually 20 per cent decline).

What has caused this selloff , and what should one do now?

The answer to the first question is very easy. Investors are finally accepting that the US is either already in a recession or about to enter one. There is also a growing feeling that this downturn will be a lot more difficult to counteract than previous economic slowdowns. The sell-side economists are going around propagating the view of "slower for longer" to describe the US growth outlook. This recession will be led by cutbacks in consumption, the engine of US growth (accounting for 72 per cent of GDP), and thus should be far deeper and more impacting than the downturn of 2001, led by business capital spending (capital spending was only 13 per cent of US GDP). The US consumer has steadily drawn down on his/her savings to an extent that income-based savings are virtually non-existent, and have relied on rising asset prices (mainly housing) and the ability to monetise the elevated asset values to sustain consumption over the last many years. This game is now coming to an end as asset prices have reversed and the credit squeeze is limiting the ability of consumers to monetise their asset values.

The so-called revolution in consumer credit. enabled by the boom in structured finance, has clearly ended, with the obvious consequence of reduced access to credit for the majority of main street America. Thus, the party of consumption growth exceeding income growth will not continue and finally the US consumer seems to be on the verge of capitulation.

The bears are convinced that a US recession, driven by low consumption, will drag the whole world down with it, and cannot see how the rest of the world can decouple. The related problem is China, where all the rate and reserve hikes over the past 12 months can finally begin to bite. There is a growing feeling that China will slow considerably in 2008, with both exports decelerating and domestic demand impacted by the lagged effects of the tightening. If China were to have a growth scare then all talk of decoupling will have to go out of the window. All the decoupling believers point to China being more important to the emerging markets than the US is, and trot out statistics of how for the EM countries, exports to China are now larger than their exports to the US. They also point out in defence of China itself how more of China's exports are now intra-EM than directed to the US. The fact is that if China were to slow, as many commentators now think, and as indicators like the collapse of the Baltic dry bulk now point to, then we have a serious global growth challenge ahead. The growth challenge is also not short-term as again investors are beginning to understand that a consumer-led recession, with a broken financial architecture, is far more difficult to reverse than the capex-driven slowdown of 2001.

The fact that the EM asset class is leading the markets down seems to indicate greater concern on China and on the duration and depth of any US recession than was the case in August last year. Back in August everyone thought that the EMs would be fine irrespective of the US outlook, the change at the margin is clearly due to greater worries on the China growth outlook.

There is also growing realisation that the problems in the global financial system will not end simply with the write-downs and recaps. We now have the whole issue of the bond insurers losing their AAA ratings and the new cycle of write-offs and losses this will trigger. We seem to be in a bit of a financial black hole, with no apparent end in sight, and with no answer as to how much new capital the system will really need. There also seems to be some doubt on all the sovereign wealth fund deals, as rumours seem to indicate that these deals have "puts, resets and other opt-outs" for the investors and are not clean straight capital infusions.

As for what one can do now, it is probably too late to sell already, and thus one will have to get through this period of volatility and hang in there. It looks unlikely that the Indian economy will grow at less than 8 per cent in calendar 2008, with the capex cycle still in full swing and no real issues in terms of either funding or management confidence. We will have another year of strong earnings growth in 2008, with an earnings trajectory of 20 per cent still on for this year. The next move in rates is also clearly down, which should help to stabilise the PE multiples as well as give a fillip to retail lending.

What we have therefore is a market down about 20 per cent, and where most of the froth has been knocked off. This correction, though obviously painful, is excellent from the point of view of extending the cycle, as PE multiples normalise and we get a chance to grow into our valuations. It will also stop many of the excesses in terms of opportunistic fund raising and the market's willingness to look at embedded value for just about anything.

We remain one of the best growth stories in the world as well as one of the most sustainable. One can find stocks again where the risk/return is in your favour.

The fly in the ointment could be the possibility of some type of global financial crisis. The way markets have traded over the last few days, we are seeing large amounts of forced liquidation. This could be either due to forced deleveraging or some type of financial institution in distress. A financial accident type of event is obviously unforecastable, but otherwise longer-term investors must use this meltdown to buy and lock in stocks they have been eyeing for some time now. For the retail players, this episode once again highlights the dangers of leverage and overtrading.