Optimism stalls amid second thoughts on recovery

By Steven C. Johnson - Analysis

NEW YORK (Reuters) - After months of wishful thinking, investors are nervous again about financial markets and the world economy, and it may take a flurry of much better economic data to make them believe in a sustainable recovery.

Anxiety grew on Monday after the World Bank cut its 2009 global growth forecast, saying the world economy will contract 2.9 percent this year.

That added to a decline that has hit major markets identified with increased risk -- global stock markets, currencies such as the euro, and oil, copper, gold and other commodities.

All three recently hit multi-month highs -- U.S. stocks surged nearly 40 percent from a bear market low hit in March -- as markets bet the worst of the global financial crisis had passed and the world recession was easing.

But these moves stalled this month, leaving the benchmark S&P 500 .SPX in the red for the year at Monday's close.

The dollar has also clawed back some of the losses suffered when growing optimism sparked investors to buy the euro and higher-yielding, commodity-linked currencies such as the Australian dollar instead, while U.S. bond yields have retreated from this month's eight-month highs.

"Markets have woken up to a world where a lot of the 'green shoots' arguments are starting to look very questionable," said Citigroup technical analyst Shyam Devani in London. "The market is uncomfortable and price action is beginning to reflect that."

The next step, he said, may be "a decent pullback in stocks, commodities and yields, and possibly a complete reversal of the greenshoot arguments."

Lena Komileva, G7 economist at Tullett Prebon in London, said a stock- and commodity-market rally was only partly driven by modestly improved economic data.

Instead, she said investors bruised and bloodied by last year's Lehman Brothers collapse and the subsequent deep freeze in credit breathed a collective sigh of relief this spring when near-zero interest rates and a sea of new money from central banks helped stabilize markets and put a floor under prices.

"But stabilization is not recovery, and to have recovery we need to see the liquidity that generated the gravity-defying rally in equities and commodities and currency carry trades find its way into the financial system," she said.

DATA MUST SUPPORT RECOVERY HOPES

So far, that hasn't been happening regularly. The Federal Reserve has pumped money into the U.S. banking system, cut rates to zero and tried to control longer-dated rates through direct Treasury purchases, all with limited results.

What's more, "households are in the process of selling or reducing debt, not borrowing and spending," said Hugh Johnson, chairman of Johnson-Illington Advisors in Albany, New York. "It's hard to make a case for a recovery in those conditions."

Even if the U.S. economy starts to grow by year-end, he said the recovery will be anemic, with higher oil prices, long-term bond yields and mortgage rates all biting. "I'd expect a 5 to 15 percent correction in stock prices and, candidly, I think 15 percent looks closer to the mark."