Will stock markets see a 14% plunge next month?

The M&A and private equity booms have been one of the driving forces behind recent stock market gains, so it’s no surprise that the prospect of the boom ending has dented stock markets.

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Last week, global stock markets finally woke up to the fact that all is not well with their cousins, the credit markets.

The FTSE 100 ended the week down more than 100 points, as concerns about the US subprime mortgage market started to spread to other areas. Of particular concern is the leveraged buy-out market, where deals agreed months ago are running into funding troubles.

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Given that the M&A and private equity booms have been one of the key driving forces behind recent stock market gains, it's no surprise that the prospect of the boom ending has dented stock markets.

And investment bank Morgan Stanley reckons there could be a lot more to come

Nerves are spreading from the credit markets to the equity markets. The meltdown in US subprime has sent spreads on high-yield corporate debt from 6.9% to 8.2% in a month, says Ambrose Evans-Pritchard in The Telegraph. In other words, investors are now expecting a much bigger payout in return for lending their money to mid-sized companies.

The most high-profile potential casualty of the squeeze is private equity group KKR's Alliance Boots takeover. The banking consortium behind the deal has yet to find buyers for the £9bn of debt needed to cover the deal.

But this is just the tip of the iceberg. Investment banks "are already sitting on a $100bn glut of debt from previous buyouts that they have so far been unable to offload to investors a further $270bn will hit the market later this year."

The issue here is not so very different from the subprime problems. The banks lend the money to fund the deal, then sell the debt to other investors like pension funds and hedge funds. Trouble is, there's that tricky gap between when they agree to lend the money, and actually offloading it.

While times were booming, they fought each other to win buyout business and the fees that came with it. Just like the subprime mortgage lenders, credit quality was the last thing on their minds. At one stage (and this probably marked a top), banks were even lending below the base rate, such was the drive for new business.

But as the credit markets have become less welcoming, all of a sudden, the banks are left with a heap of funding commitments and no one to offload them onto. As Evans-Pritchard puts it: "This could leave the banks with far more risk on their books than they bargained for, and could ultimately force them to pull back sharply on lending."

That of course, would spell an end to whopper buy-out deals. And that's not good news for an equity market that's been propped up by traders looking for the next record-breaking buyout.

Morgan Stanley has found that in the past 20 years, credit spreads began to widen an average six months before every stock market correction of 10% or more. The current widening in spreads began in February - so that would point to a correction as early as next month. Evans-Pritchard reports that the Morgan Stanley model suggests a 14% fall in the Dow Jones index.

We shouldn't be surprised though. As Teun Draaisma, the bank's chief European strategist says, "equities have reached all-time highs despite higher rates, higher oil, Chinese tightening and a stronger euro."

If anything, it's a miracle that we haven't already seen a correction.

We'll be looking at what my colleague James Ferguson has described in his Model Investor service as "the Great 2008 Credit Crunch" could mean for your investments in the next issue of Money Week (out this Friday).

Turning to the wider markets

On Friday, the FTSE 100 ended 55 points lower at 6,585. Bidding rumours drove Friends Provident higher, climbing 4.25% to 186p. For a full market report, see: London market close

On the Continent, stocks also ended lower, shaken by US subprime fears. The Paris CAC-40 was 108 points lower, at 5,957, and the Frankfurt DAX-30 was 116 points down, at 7,874.

Across the Atlantic, the Dow Jones fell 149 points to close at 13,851, a weekly loss of 0.4%, despite it breaching the 14,000 mark for the first time ever on Thursday. The tech-laden Nasdaq was 32 points lower, at 2,687, and the S&P 500 was 19 points lower, at 1,534.

In Asia, this morning, the Nikkei fell 194 points to 17,963 today, with exporters down on fears of a US slowdown. Meanwhile, the Hang Seng gained 52 point to 23,344.

Crude oil was trading at around $75.50 this morning in New York, while Brent Spot was at $79.35 in London.

Spot gold was trading at around $684 this morning. (For in-depth daily gold reports, see: investing in gold. Silver, meanwhile, was trading at $13.38.

In the currency markets, the pound was at 2.0584 against the dollar and 1.4881 against the euro this morning. And the dollar was at 0.7230 against the euro and 120.96 against the Japanese yen.

And in London this morning, Barclays has raised its offer for Dutch bank ABN Amro to $93.4bn, with the backing of both the Chinese and Singaporean governments. The new bid is worth 35.73 euros a share, still beneath the 38.40 euros-a-share offer made by Royal Bank of Scotland's consortium last week.

And our two recommended articles for today...

Will oil hit $150 a barrel by 2010?- It's official: the energy crunch is coming. Or so Investec fund manager Tim Guinness predicted last week, along with the International Energy Agency. For more on the latest doom-mongering from the oil industry, read: Will oil hit $150 a barrel by 2010?

What next for property fund investors?- There are still calming voices pointing out that the property market remains secure in the long-term, but for those heavily invested in commercial property funds the outlook is anything but. For more on the outlook for the commercial property market and who is set to suffer most from a slump click here: What next for property fund investors?

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.