Shoe on the Other Foot.

Byline: Ruchir Sharma

When asked why evil exists in the world, the Indian saint Ramakrishna answered: "To thicken the plot." Well, volatility plays a similar role in the financial marketplace. Major trends tend to last for years and often define a decade, A la Japan in the 1980s, the U.S. tech boom in the 1990s or emerging markets since. But in between there are several twists and turns to juice up the plot.

The latest bout of global market turbulence should be viewed from that perspective. Financial-market volatility fell to record low levels earlier this year, signaling investors had become too complacent. While trouble had been brewing in the U.S. housing market for several months, many investors were willing to overlook it, instead holding on to the belief that in an environment of easy money and strong world growth, no problem could be serious enough to derail the global bull market for stocks.

However, with the crisis of confidence in the U.S. credit market over the past few weeks, assumptions underlying the big trends of this decade are being questioned. Emerging markets have been the asset class of choice this decade, rising by nearly 300 percent from the October 2002 lows, due to rapidly improving economic fundamentals, including rising foreign-exchange surpluses and falling inflationary expectations. But in the past month, as foreigners have pulled more money from emerging stock markets than in any other decline, old fears have resurfaced about how these markets are doomed to rise and fall with American mood swings.

The important questions for investors, then, are: does the credit crisis have the potential to become a full-fledged systemic shock that breaks the back of the U.S. economy, and, if that happens, what are the implications for growth in the emerging markets? Given the key role the U.S. housing market has played in the current economic cycle, it seems unlikely that the unwinding of such a massive credit cycle will have no macroeconomic follow-through.

The best-case scenario for the U.S. economy is subpar economic growth. However, it should be able to avoid a recession due to the strength of corporate balance sheets. After all, corporations in the U.S. are flush with cash, have little leverage and--most important--overseas sales account for an increasing share of their earnings. But the fate of the global economic expansion will more likely be determined by ...