Three reasons to be gloomy

The FTSE 100 and S&P 500 have both hit 6-year highs in recent days, but are investors paying enough attention to risks? Here are three clouds on the horizon which you can't ignore.

It's onwards and upwards for stocks, with the S&P 500 and the FTSE 100 reaching six-year highs last week. But investors "do not appear to be paying enough attention to the risks in the outlook", as Merrill Lynch puts it. One cloud over the US market is a slowdown in profit growth, hitherto a key driver of market gains: Francesco Guerrera in the FT notes that 22% of the S&P 500 firms that have reported results so far for the fourth quarter of 2006 failed to meet analysts' expectations, the highest number of misses since the third quarter of 2004. That presages an end to a three-and-a-half-year run of double-digit quarterly profit gains. We are finally "entering a low-earnings growth environment", says Ashwani Kaul of Reuters Estimates.

And Merrill Lynch warned last week that the liquidity boom that has buoyed asset markets everywhere is drying up as Europe and Japan look set to raise interest rates; worldwide liquidity growth has already receded from 22% in late 2005 to around 10%. "We are later in the credit cycle than the consensus seems to believe," says the bank. Tighter credit heralds greater market volatility and an economic slowdown. Merrill Lynch advises shifting to safer assets, such as high-yielding stocks, and warns of further trouble ahead in the US housing market, which is bad news for growth.

That theme took centre stage again last week as HSBC was forced to issue its first ever profits warning. It is the third-largest provider of subprime mortgage loans (made to those with poor credit histories) in the US, thanks to its ownership of Household Financial, and has been hit by unexpectedly high default rates in this sector. It is setting aside 20% more than analysts estimated to cover bad loans in 2006 depriving the group of half its overall profit growth. The number two subprime mortgage player, New Century Financial, will also take a loss for the fourth quarter thanks to rapid defaults.

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With house prices falling across most of the country, homeowners can no longer pay off loans by refinancing their mortgages. And since rates have been moving higher at the same time, "many subprime borrowers are being forced to default", says Eric Fry on The default rate among these financially stretched borrowers hit a decade high of 10% in November, and the Center for Responsible Lending predicts 19% of the subprime mortgages originated during the past two years will end in foreclosure; moreover, 18 subprime mortgage lenders have already gone broke.

The malaise in the subprime segment bodes ill for the entire US housing market, says Fry. Lax lending standards during the recent boom have meant that many borrowers with poor credit histories have been granted mortgages: the subprime share of all mortgage originations reached about 23% last year. And many of these mortgages contained "toxic features", such as "adjustable" rates, which climb with short-term interest rates. These comprised 40% of all mortgages issued in 2006, and with about $390bn worth to be reset upwards this year, "defaults should spiral higher", says Jonathan Laing in Barron's.

With subprime mortgage lending "a leading indicator for the rest of the economy", investors could be facing "a slow-motion crash" in the US, says Martin Fluck in Barron's. The chief worry is a mortgage credit crunch as lenders tighten their standards across the market. Politicians are demanding a further clampdown on risky mortgage products, while a recent Federal Reserve survey found that more banks have been tightening lending standards than in any quarter since the 1990s. Meanwhile, mortgage originations are falling.

A mortgage credit crunch would have a "severe economic impact", says Edward Chancellor on Breakingviews. HSBC's economists have been warning that a slower housing market would result in less consumer borrowing and thus hurt the economy. Clearly, nobody in the mortgage unit "bothered to read these gloomy reports".