Having largely passed the second-quarter corporate earnings test without major shocks, the next hurdle for global financial markets is likely to be the eventual withdrawal of extra cash injected by central banks.
In this context, the outcome of next week's Federal Reserve's monetary policy meeting will be crucial.
While the Bank of England expanded its quantitative easing plan to 175 billion pounds on Thursday, comments from Fed officials suggest the U.S. central bank's $300-billion programme to buy longer-dated Treasuries is likely to expire on schedule in September.
Investors are already pricing in a chance of an interest rate hike as early as December with some arguing that the Fed's efforts to mend credit markets have sown seeds for inflation.
World stocks, measured by MSCI, hit their highest level in nearly 10 months this week, helped by positive earnings. According to Thomson Reuters data, of 414 S&P 500 index companies which have already reported results, 73 percent have beat estimates.
The quarterly earnings contraction rate for the second quarter stands at 28.4 percent, compared with 35.5 percent in the first three months.
"The Q2 test has been passed and exceeded. But positive surprises have been down to cost cutting and it's filtering through. I think in the third and fourth quarter we will see improvement in the revenue stream," said James Thomson, investment director at Rathbones.
"Equity markets globally will be bumpy. There will be a very sharp move upwards of 10 percent, followed by correction. Fund managers love a nice gently move upwards but we are not going to get that."
Thomson's Global Opportunities Fund currently has 14 percent in cash, down from 38 percent at the end of 2008.
"It reflects continued uncertainties," he said of high cash allocation.
Thomson has a watchlist of around 30 companies, which he intends to buy when they meet the criteria — which include earnings and improvement in fundamentals, as well as specific factors such as contract wins or higher capital spending.
"The most important decision is to buy right companies. They will be more volatile, high beta. It's the price to pay for getting higher returns," he said.
FED AND LOW RETURNS
The Federal Reserve meets on Tuesday and Wednesday to review the outlook for growth. The Fed is seen opting not to prolong Treasury buying, while officials are expected to reinforce their message of no imminent exit from bold policy steps to end the U.S. recession.
"Central banks would want to be slow in raising interest rates. That's why return on cash is going to be low. The worst asset to have is cash in the next few years," said Jeremy Beckwith, chief investment officer of UK-based private bank Kleinwort Benson.
He reckons investors are at the early stage of a bull market, although sharp move upwards are unlikely given sluggish growth.
"It's going to be a slow bull market. Directionality becomes more confused and we will have sideways trading, within a rising trend, in the next 12-24 months. There will be very little growth and the market is going to trade around."
Bank of England's new quarterly inflation forecast, due on Wednesday, is likely to give clues on when the central bank might unwind its massive easing programme. The BoE said it could take about 9 months for the impact of quantitative easing to become visible.
STELLAR PERFORMANCE
Riding on a risk asset boom, hedge funds are giving their best performance in 10 years.
The hedge fund aggregate average index, compiled by HedgeFund.net, rose 11.89 percent for the first seven months of 2009. This compares with 10.97 percent for the S&P 500 total return index.
Convertible arbitrage funds — which aim to profit from buying convertible securities and selling corresponding stocks, returned over 6 percent and are the best performing strategy in 2009. Other leading strategies included long only, emerging markets and focuses on energy and mortgage sectors.
Short bias and managed futures — the best performing strategies last year — lagged, along with asset-based lending and market neutral equity.
Drawdowns — periods below prior peak net asset value — persisted, however the rate is decreasing. At the end of July, 66 percent of funds were in the near-term drawdowns, compared with 74 percent at the end of 2008.
Fifty-four percent of funds in the HFN database are below 2008 levels.
