Calm before storm in stocks

published 31 October 2005

Most of the world's markets have gone precisely nowhere this year. Japan's Nikkei 225 index is up 10% in 2004, thanks to growing confidence in the sustainability of Japan's economic recovery, and eastern Europe has soared as its accession to the EU highlighted its attraction as a convergence play. But Germany's Dax, America's S&P 500 and Britain's FTSE 100 indices have barely budged as positive earnings news has been overshadowed by jitters over terrorism, oil prices and the prospect of rising rates. So what might get them moving in the second half?

When it comes to the FTSE, that's a tricky question, says Christian Schubert in the Frankfurter Allgemeine Zeitung. Merrill Lynch notes that consumers are spending more of their disposable income on servicing debt than at the peak of the last two economic upswings. That, along with likely further rate rises, bodes ill for consumption and growth. Meanwhile, recent corporate newsflow "offers few reasons to be cheerful", says www.Dailyreckoning.com. According to Experian's Corporate Health Check, corporate profitability has hit a record low, with the average return on capital employed slumping to 4.8% in the third quarter of 2003. This marked the 18th successive quarterly slide. Only sectors juiced by historically low interest rates saw an upturn in profitability. Yet now banks' profitability is also declining. HSBC is slashing jobs from its high-cost UK division and Lloyds TSB has admitted its net interest margin has dropped by 3%. A further reason to fear a rockier ride in the next half is that America's VIX gauge of market volatility is below 20, a level which since 2000 has presaged a rise in volatility and a slide on Wall Street and in London.

There are other reasons to be sceptical about rosy forecasts for US stocks, says Philip Coggan in the FT. The economy is set to slow as the impact of the Bush administration's tax cuts diminishes over the next few months. Moreover, higher bond yields are already crimping mortgage refinancing, a key driver of consumption, and mortgage applications slumped by 60% in the year to mid-June. It will soon become clear that the Fed can't prop up a weakening economy by slashing rates - but also can't raise them sharply to clamp down on returning inflation, owing to the economy's massive debt load, says Bill Fleckenstein of Fleckenstein Capital on www.MSNMoney.com. The realisation that the Fed hasn't managed to revive the post-bubble economy should soon send stocks into a slide. This is "the calm before the storm".