Stockmarkets: nasty surprises round the corner?

Stockmarkets may have bounced back to pre-credit crisis levels thanks to the Fed's surprise half-point rate cut. But there are plenty of clouds still on the horizon.

"You couldn't mix a better drink for the stockmarket," says James Paulson of Wells Capital. The Federal Reserve's surprise half-point interest rate cut propelled Wall Street to its best week in six months as investors bet lower rates would bolster the economy. The S&P 500 is back to around 2% below its all-time high, while the FTSE 100 has regained late July's levels. A slump in the widely monitored US volatility index a gauge of fear in the market also underlines the bullish mood. In Britain, fund managers including veteran investor Bill Mott have been buying bank shares; Mott reckons sentiment towards the sector has hit rock bottom and can only improve. Anthony Bolton has also increased his exposure to financials.

The Fed's aggressive move has fuelled the belief that further cuts may be in store to pre-empt economic weakness. Gerald Minack of Morgan Stanley says: "Rate cuts are like tequila shots you rarely have just one." Rate cuts are generally good news for markets: since 1970, the average gain in the S&P 500 index six months after the first rate cut has been 12.3%. UK stocks have typically been almost 10% higher after the Fed's first rate cut in the same time span, calculates Citigroup; over 12 months, they have on average gained 20%.

Only in 1987 and 2001 was the UK market lower after a year; on the latter occasion, the Fed's cuts did nothing to prevent the post-dotcom-boom recession, leaving the S&P 500 43% down by late 2002. The trouble is that, as in 2001, we are seeing "the unwinding of an asset and credit bubble and the ensuing deleveraging process, which tend to play out despite the Fed's efforts", says Merrill Lynch's David Rosenberg.

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On the US housing front, the deflation of the bubble looks unstoppable. Tighter loan standards are likely to remove around 10%-15% of the buyers that were in the market over the past two years, notes John Mauldin of The massive inventory build-up, exacerbated by surging defaults set to jump as a wave of adjustable rate mortgages are reset upwards also points to further price falls; according to Robert Shiller of Yale, prices could plummet by up to 50% in some areas.

It hardly helps matters that long-term rates, to which most mortgage rates are linked, are on the rise amid worries over inflation. The impending slowdown in consumption hitherto underpinned by high house prices via the wealth effect and mortgage equity withdrawal threatens to turn the housing slump into a general recession.

Meanwhile, interbank rates have eased but remain elevated. Banks are going to take time to regain trust in each other and are likely to remain wary of lending. "Many people and businesses will have to pay more to borrow, or may not be able to borrow at all," says The Economist; last week Standard & Poor's warned of a new wave of business failures in the US as weak, highly leveraged firms default on $35bn of debt owing to the credit crunch.

In Britain, tighter lending criteria witness Barclaycard's reduced credit limits this week and higher spreads will effectively raise the Bank's interest rate by 1%-2%, says Roger Bootle in The Daily Telegraph. The Centre for Economics and Business Research warns that growth is set to slow to 1.4% next year, down from 2.7% in 2007, thanks to the credit crunch.

On top of all this, there is still ample scope for nasty surprises to rattle investors because nobody knows where exactly the losses on mortgage-based derivatives lie. To compound the uncertainty, it will take time for banks to price the complicated assets for which they are ultimately liable, says The Economist. Given all this, the latest market rebound, as Steven Leuthold of Leuthold Core Investment fund puts it, looks like "the eye of the hurricane".