• Bad economic news is now largely priced in
• Worries remain over global terrorism and the financial sector
• Overcapacity and high debt mean it is still hard to make money

The world's major equity markets ended last week on a high note. On Friday, despite weak US data on both retail sales (the biggest drop in ten months) and consumer confidence (down to its lowest level in nine years), the Dow closed up more than 300 points. The positive message is that this shows how much bad economic news is already priced into equity markets. Investors focussed instead on upbeat results from a handful of major US companies, led by the 25% rise in profits reported by General Electric.

Unfortunately there are two clear threats to the recovery in sentiment this week. The first is immediate: the impact of the weekend's atrocities in Indonesia, where (as I write) at least 182 people have been confirmed dead in the bombing of a tourist resort in Bali. Global terrorism had dropped down the list of market worries in recent weeks, but now it will be right back on top again. This is clearly bad news for equity markets both in the region and globally.

The second threat comes from the remainder of the earnings season. Roughly a third of the large US companies report their Q3 earnings this week. The news will cover all major sectors, including names such as Boeing, Coca-Cola and Microsoft. However the focus will probably be on the US banks. Weakness in the financial sector is now a global theme. There are real worries about banks in Europe (especially Germany) and Japan. Even in the UK, where the economy is doing relatively well, there are concerns about bank exposure to problems in the electricity sector.

The US banking results this week will therefore be especially important. Watch in particular for the numbers from Merrill Lynch, Citigroup and JP Morgan Chase. The news here will not be good. Optimists will hope that the impact will be limited by the fact that - just like the bad economic data on Friday - so much bad news is already known. JP Morgan in particular has already been downgraded by both Moody's and S+P. It has also warned that Q3 profits will be well below those in Q2, mainly due to higher provisions on corporate lending.

Pessimists, however, will emphasise how difficult it is for any company to make money in the current environment. Even though equities have fallen to attractive levels on longer-term valuation measures, it is too soon to be over-weight. This week's charts illustrate two reasons why US companies will find it hard to raise prices enough to rebuild margins. First, capacity utilisation is low, so competition is strong. Secondly, consumer debt is high, so consumers still need to see bargains to keep them spending. Stay neutral stocks, at least for now.

Julian Jessop
Economist
Tel: 44 20 7280 6690

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