Three reasons why good times can be bad for stocks

Let's hope there isn't too much good news over the coming months.

It's a common misconception that when business is booming and the economy is powering ahead, that's good for equity investors. But it's obviously not true.

China has consistently delivered sizzling economic growth in recent years, yet its stock markets have been among the world's worst performers.

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That's not an isolated example. After analyzing more than a century of stock market history, investment bank ABN-Amro concluded: "There is no apparent relationship between GDP growth and equity returns."

At present there is a lot of optimism about the outlook for the major economies. The US is expected to continue growing at a cracking pace, Europe to speed up, and Japan to maintain the momentum of its strong recovery.

You might think that should be good for investors. Not so. Consider the implications

Rising interest rates

If economic growth remains buoyant, central banks will consider it safe to continue cutting back on their profligate credit creation of recent years. The Americans want to rebuild their capacity to deal with future crises (the higher they push interest rates, the bigger the potential for later cutting them), the Europeans want to combat inflation and the Japanese to stop dishing out free money.

Rising interest rates are bad for equities, bonds and especially real estate.

Rising inflation

The forecasters don't expect a problem over the next year or two, but I think they could be wrong.

It's becoming increasingly recognized that official consumer price index figures are fraudulent manipulated to keep them artificially low. The most obvious example is the exclusion of energy costs from so-called "core" inflation indexes on the grounds that current high costs are temporary. In America just one piece of statistical sleight-of-hand, "geometric weighting," has been estimated to cut reported consumer inflation by an average of 2.7 percentage points a year.

High and probably rising energy prices, the emergence of some labour shortages in the US and Japan, and the increasing cost of credit, are just some of the factors that could combine to outweigh the deflationary effects of globalization and soon start pushing up prices faster than the experts forecast, at least in the short term.

Higher input costs will threaten corporate profits. Central banks, well aware that official indexes already seriously underestimate inflation, will continue raising interest rates more aggressively than the markets currently expect.

Asian earthquakes

Strong growth in the Asian economies is likely to start having unpleasant consequences elsewhere, especially in the US and Europe. And not just because their manufacturing industries are being destroyed by Asian competition.

Sustained recovery in their own economy, if it comes about, will encourage the Japanese to invest more at home, especially if the yen starts to strengthen. Hong Kong-based Gave-Kal Research says: "Japanese private savers have been huge buyers of US and European bonds The biggest threat to the global bond market has to be that Japanese savers discover better returns at home."

China poses a different threat. It wants to recycle its huge and growing export surpluses into buying real assets around the world -- established companies that own markets, technological knowhow and natural resources. There is fast-rising opposition to such takeovers. The Chinese will undoubtedly counter-attack such rising protectionism with unpredictable, but almost certainly disruptive, consequences.

Of course, none of the above is likely to happen if the economic forecasts turn out to be far too optimistic which could well happen. Rising interest rates and a slowdown in the property market could put a brake on consumer demand growth in the US; Japanese consumers could refuse to go on the spending spree that everyone's urging on them; arthritic Europe could continue to disappoint.

In that case, we could expect interest rates to stop rising (perhaps even start falling), inflation to remain sluggish, and the Asians and once-again-rich Arabs to continue recycling their surpluses to the profligate West.

Lovely for investors at least for a while.

By Martin Spring in On Target, a private newsletter on global strategy