The turmoil induced by the ongoing sub-prime saga, its consequential credit crunch and Central Bank reactions have certainly kept markets and commentators very busy this week. Although the message seemed more gloom than doom, a certain camp of optimists have undoubtedly been more vocal of late. Their cup seems to be half full of joy with the notion of so called decoupling, pinning their hopes that the drag that now is a virtual certainty Stateside will steer well clear of the Asia and slightly less so of Europe.

Certainly so far, this seems to have been the case for Asia’s giants. India’s Sensex index and China’s Shanghai index have kept climbing to reach all time highs. In fact for the quarter so far, the indices have returned 13.4% and 42.8% respectively in local terms, seemingly putting paid to that old adage ‘when the US sneezes, the rest of the world catches a cold’. These equity markets may yet see more highs if global investors now choose to increasingly look at emerging markets as a recourse in the case of the US slowdown.

If you were to canvas opinions amongst bankers, there are many that believe the US has become a relatively less important destination for the rest of the world’s exports. The US now accounts for less of Asia’s total exports – about 20% lower in 2006 than in the year 2000. This indicates that even if the current slowdown in US housing puts a crimp in consumer spending, domestic demand from Asia and Europe will pick up the slack and offset some of the decrease in US demand. Even in Japan where consumer spending has been anaemic, there are signs of optimism. The Government last week said its index of business confidence among large Japanese companies rebounded to 6.2 in the three months to September from -0.9 in the previous quarter. Given the underlying solid trend in the corporate sector and export demand from the rest of Asia will remain intact, forecasts of a GDP growth rebound in Q3 are not completely unrealistic and Japan may well escape the fallout from the US.

In contrast to Asia, Europe appears to be more of a mixed bag and although opinions remain rather more wary of Europe’s scope to decouple, European Central Bank president Mr Trichet remained upbeat about the region’s fortunes. He reiterated that economic fundamentals remained strong and that growth outlook was favourable. Another trump card in the decoupling camp has been the shift in rate expectations. Even given the 0.50% cut by the Federal Reserve this week, the expectation is that the ECB will hold its line on interest rates, suggesting the weakness would not spread to Europe to warrant a cut.

While the voices shouting the decoupling theory may be growing stronger, it is important to remember that the world is now a smaller place and it is hard to run away from the forces of globalization. It is true to say the current crisis specifically surrounds the US housing market, but it would be unwise to assume that the financial market turbulence will have no real effect. If anything, the financial markets have more than aptly demonstrated that credit problems and the re-pricing of collateralized debt securities backed by sub-prime mortgages have a way of spreading across the globe with surprising speed, managing to ensnare the UK’s high street banks in the process. It is also worthwhile considering what would happen if the slowdown in US housing was to manifest elsewhere across the globe. There are already signs of weaker real estate prices in the UK and it may be a while before the full impact on the European property market shows through. The decoupling theory also holds less ground in the event of a stronger US slowdown than anticipated, or a recession, in which case there may be nowhere to hide. China will most likely be involved in a major economic slowdown and given just how intertwined the global markets are, the world economy may not be able to escape the adverse repercussions.

***

And finally……….It’s certainly been a week of firsts. Not only did I experience my first Fed rate cut in my working career, I also had the not so pleasurable joy of watching for the first time Paddington Bear pull out a marmite sandwich from his hat. Whatever next?! Feeling overwhelmed by too much change, I was soon reassured when the bear’s creator Michael Bond said that “bears are creatures of habit” and that “it would require a good deal more than the combined current withdrawals from Northern Rock to wean him off marmalade”.

Have a good week,

Aparna Ram
Research Analyst
Seven Investment Management