The Shanghai Composite Index slipped below the 5,000 mark on Thursday and the index has given up nearly 19% from its peak. The Hang Seng Index has fallen 18.6% from its highs.

If, as CLSA strategist Christopher Wood said a few days ago to Mint, the key to Indian stock valuations depends on China, then the Sensex, which is 8.5% away from its top, still has some catching up to do on the way downward. The story so far has been that while the US economy may head for the doldrums, growth will continue in the emerging markets and that will lead to money pouring into these markets, driving up stock prices.

For a brief period in September and October, that was precisely what happened. But this month, that particular plot seems to have been lost.

The question is: Will emerging markets sink along with the markets affected by the credit crunch? This is what the Asian Development Bank (ADB) had to say in its November report on the East Asian bond market: “Prolonged global financial market volatility, persistent risk aversion together with a re-pricing of credit risk could lead to a reversal of capital flows (particularly “carry trades") to the region."

At the moment, with the yen below 109 to the dollar and with the US treasury yield below 4%, the rise in risk aversion is obvious.

At the same time, ADB pointed out: “Although the external environment has weakened recently and downside risks have intensified, many economies in emerging East Asia have benefited from improved macroeconomic fundamentals, largely benign domestic conditions, strong external balances and prudent economic management."

ADB also said that China, India and Russia together accounted for more than half of world growth. A recent Citigroup Inc. report forecasts that, while US gross domestic product (GDP) growth would slow to 2.3% in 2008, India’s GDP growth is likely to be 9.4% and China’s 11%. But it’s also true that whenever there has been a sell-off in the last few years, emerging markets too have tottered. Will this time be different? Everything depends on the impact on liquidity. Banks hit by the subprime crisis will be reluctant to lend and that will lead to a contraction in credit. As the Citigroup report says, “The withdrawal of liquidity from financial markets owing to banks’ retrenchment could spill over more meaningfully to emerging markets."

Of course, the US Fed can always pump in liquidity by cutting interest rates, although it has indicated that it is no longer very enthusiastic about doing that. But even if it does, success may not be assured. Recall that in 2001, the Fed cut its policy rate 12 times—pulling it down from 6% to 1.25%, but that didn’t prevent the market from a meltdown.


Siemens Ltd’s results for the year ended September 2007 demonstrate why investors are gung-ho about shares in the capital goods space. The company reported a huge 71% growth in revenues on last year’s relatively high base of Rs4,542 crore. Core profit before tax and non-operating income rose 52%, to Rs551.5 crore, after adjusting for a foreign exchange gain of Rs128.5 crore.

In the previous financial year, core profit had grown 38%, on the back of a 62% rise in revenues. Thus, the company has faced margin pressure for two years in succession. In addition, with the base getting higher, it seems to be increasingly difficult to maintain high growth rates. Siemens’ order book, for instance, has grown just 25% in the year till September.

The key power segment, which accounted for 68% of both revenue and profit growth last financial year, reported a mere 11% growth in the order book. This, the company explains, was because the previous financial year included a higher number of mega orders.

Excluding the effect of mega orders received in both years, the increase in order book is higher at 24%. It’s important to note here that competitor ABB, formerly Asea Brown Boveri, has grown its order book by 35% in the January-September period. The growth in Siemens’ order book in the year till September 2006 was as much as 97%, propped by mega order wins in the power business. This represents an unusually high base, over which even the 25% growth achieved this year seems reasonable. Also, adjusted for the foreign exchange gain in last year’s results, the company’s valuation has changed much from last year’s level of 55 times trailing consolidated earnings. The markets don’t seem too worried about a high base catching up with Siemens. It’s either that or just the demand-supply mismatch for capital goods shares that ensures firm valuations.

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