As I have outlined before in many previous articles, I remain of the view that the United States is heading for a severe growth slowdown and most probably a recession in 2008, and this will be negative for stock prices globally.

As discussed before, in a recession-type of an environment, even a Fed determined to keep cutting rates cannot save the markets. All the bullishness surrounding Fed easing cycles are true provided the US were to not slip into a recession; otherwise all bets are off.

However, given the importance for investors of getting this call right, it is worth highlighting the contrarian view. There is a large body of opinion that the Fed can save the US economy and that a recession is an unlikely outcome. The bulls also feel that it is unlikely that inflationary tendencies will surface to slow the ability of the Fed to continue easing.

This camp is understandably a lot more positive on the markets and sees any weakness as a huge buying opportunity. I have found the arguments in this connection by the folks at Gavekal to be the most cogent.

The more positive camp bases their view on the following:

1. They point out that housing slumps in the past seem to be very highly correlated with recessions only because historically, these slumps were caused by very high interest rates. The real cause of the economic slump was the high interest rates and not the housing market downturn.

The bulls argue that the slump in housing was a byproduct of the high interest rates leading to a recession and not a cause of the recession. The bulls thus continue to argue that a housing slump not accompanied by high interest rates is not going to be as corrosive on the broad economy as is commonly believed.

Today's environment is clearly one of low and still falling rates. This thesis to an extent has been borne out by the statistics on growth till date, which continue to show the other components of the US economy continuing to grow even as housing has caved in.

Of course, the flip side to this argument is that even though rates have not spiked, the recent dislocations in credit have severely impacted its flow, which could potentially be as damaging as higher interest rates. One needs to track the extent of dislocations in credit flow to judge if the other sectors of the US economy can continue to decouple from housing.

2. The second argument of the bulls is that you have to break up the impact of the housing slump into two components -- the direct impact of falling housing investment on the economy and employment and the indirect impact of falling house prices on consumption.

The direct impact will be felt through weakness in all aspects of employment related to the housing sector, as well as a severe drop in the rate of housing investment as new homebuilding activity drops. At its peak in 2005, housing investment was over 6 per cent of GDP and has already fallen to below 4.5 per cent.

Before it stabilises, this ratio could drop further to around 3 per cent. While this falloff in investment is significant and will be a drag on the economy, what concerns investors far more is the potentially damaging wealth effects of falling house prices on consumption.

For a drop in the share of housing investment from 6 per cent to even 3 per cent by itself cannot push the US into a recession, that can only happen if consumption more broadly were to get hit. Strategists like Gavekal have argued that given that the top 20 per cent of US households consume more than the bottom 60 per cent, a housing downturn focused on the sub-prime borrower will not have as severe a fallout on economy-wide consumption as the bears fear.

They have argued that as long as interest rates remain low and employment and income growth continues in the non- residential segments of the economy, the damage to consumption should be more muted and contained than the bearish view. The continued stability of growth ex the construction sector lends some credence to this view.

3. The third leg of the bull case is based on a research paper released by the Fed in 2005, laying out a relationship between housing and trade. The paper makes the case that the collapse in housing will be largely offset by an improvement in US trade figures.

This conclusion seems to be backed by recent trade data, which show exports growing by 16 per cent and offsetting the -20 per cent drag from housing.

Basically the bulls make the argument that the weak dollar, falling yields and surge in liquidity will do enough to boost the economy and counteract economic woes induced by financial markets.

These arguments have validity, and at least we can see a construct in which a recession is not a foregone conclusion for the US.

However, markets, while initially reacting with euphoria post the initial 50 basis point Fed cut, have pretty much retraced their entire move and are now hovering at mid-August lows once again. The markets once again seem to be pricing in a recession.

The biggest area of concern has to be the rapidly deteriorating labour market situation in the US. The one indicator that investors must track from here on is the employment report -- any further weakness and a recession will be pretty much baked in the cake. The other indicator on the real economy worth tracking is the ISM survey of purchasing managers, any break in this below 50 will also be a significant negative forward-looking indicator.

The question, of course, is that even if the US were to slip into a recession as I believe, then can the emerging market (EM) equity asset class continue to decouple, as many investors continue to believe?

Certainly the price action seems to imply that this is what will happen, as most of the large EM markets are significantly above their mid-August lows. While the case for a decoupling of the real economy seems quite strong, I am not sure financial markets can decouple as seamlessly as everyone seems to expect.

I do believe that the biggest beneficiaries of the expected surge of liquidity as OECD central banks ease will be the more domestically-oriented and faster-growing large EM economies like India and China, but even these markets will have to face jitters as Wall Street gets more and more nervous on the outlook for the US.

The longer-term trend towards these large emerging markets is clear but we will have a lot more choppiness then investors are currently anticipating to my mind.

Stay invested but be prepared for some air pockets ahead.