Will 2007 be a good year for investment markets?

Why do I feel so nervous about investment markets?

The experts are virtually unanimous in predicting that 2007 will be great for equities, as the third year of the US presidential cycle usually is. Both parties seek to boost the "feel-good" factor in the run-up to the election, and they can do that through spending taxpayers' money even more profligately than normal.

The VIX the index that measures derivatives investors' consensus view of the risk from future stock market volatility is at 13-year lows.

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The central bankers' "club," the Bank for International Settlements, says investors' appetite for riskier investments suggests they're expecting the US economy to achieve a "soft landing" and the global economy to continue expanding.

In the US itself, the mountain of high-risk structured credit instruments continues to grow, despite increasing signs of stress such as a record-high foreclosure rate.

The world as a whole is still awash with abundant cheap credit that flows into all major asset classes, underpinning and generally raising asset values.

There are no signs of panic in markets that usually give early warning signs of financial trouble gold, bonds, currencies. Even the dollar, despite its well-known negatives and recent decline, is no weaker in euro or yen terms than it was a couple of years ago, and looks as if it's about to rally.

So what on earth am I worried about?

Inflation: why it will rise

I think the problem is going to be inflation higher than most experts expect.

Notwithstanding the well-known contraction of the housing-related sector, the US economy continues to grow strongly. Businesses are hiring more workers and productivity growth has slackened. Average hourly earnings are now rising at an annual rate of more than 4 per cent. All this is pushing up labour costs, the main driving force behind inflation in any economy.

If the dollar continues to weaken, as seems probable, that will add to inflation pressures by raising the cost of imports (including oil), and giving domestic producers leeway to raise prices despite competition from abroad.

If there is little or no slowing of growth in the US economy, with the emerging economies of Asia continuing to expand at 8 to 10 per cent, and the economies of Europe and Japan maintaining reasonable momentum, all of which seem probable, then it could be another year of credit-bloated demand in the world economy as a whole. That will put pressure on the prices of scarce resources such as oil, metals and high-level technical and management skills.

If the central banks detect or anticipate a pick-up in inflation pressures, there is no way they are going to stop pushing up interest rates, or even start cutting them, as the futures markets currently predict.

How would such a scenario impact on investment markets?

Inflation: consquences for investment markets

Analysts are suggesting that 2007 will be another good year for growth in corporate profits. Stronger-than-expected demand for goods and services would be good for sales. But higher costs, and loss of the prospect of lower interest rates, would provide discouraging head-winds.

Bond investors hate inflation, but they would hold their nerve if central banks showed resolve in the face of the threat.

Providing there isn't some major surprise such as a war that impacts on oil supplies, a blow-up in the financial markets, or a major terrorist incident, 2007 shouldn't turn out too badly.

But don't believe the derivatives markets have got it right with their complacent optimism about risk levels over the coming months. Investors should expect some stressful, turbulent and difficult times immediately ahead. There's a high probability of an unseasonal and largely unexpected correction in major equity markets over the next few weeks.

By MartinSpring in On Target, a private newsletter on global strategy