By Natsuko Waki
LONDON, June 9 (Reuters) - An amber light is flashing in global equity and risk markets after a two-month rally: rising yields, falling equity valuations and mixed signals on the world economy are making investors reluctant to push further.
Since world stocks, measured by MSCI, hit a 7-1/2 month high last week, they have been trading sideways, with the benchmark index off around three percent from the peak.
Benchmark U.S. Treasury yields raced to 7-month highs on Monday, adjusting for expectations of an earlier rise in Federal Reserve interest rates and deeper worries about Washington's plan to issue huge debt to finance economic support.
The rise in yields, which move inversely to bond prices, is weighing on market valuation of stocks. According to Credit Suisse, the U.S. equity risk premium -- an excess return the domestic stock market provides over theoretically risk-free Treasury rates -- has fallen to 4.7 percent from around 6.3 percent in December.
This means there is a smaller advantage for asset managers in holding equities over government bonds than before, when equity markets were screaming with once-in-a-lifetime bargains.
"It's not difficult to be sceptical about this rally given all the problems about the economy and financial issues. There's a fair chance of a double dip scenario. It's difficult to make a bullish case for the next 2-3 months," said Christian Gattiker, head of research at Julius Baer.
"Before, equities looked particularly attractive. We are now in a more normal state. Rising yields closed the valuation gap."
Gattiker said equity valuation has normalised from extreme levels because of a combination of falling earnings and rising bond yields. Furthermore, rising bond yields affect future cash flows of companies.
"You have to apply more strict valuation on equities. Given the uncertainty of price returns, we advise products that have some yields," he said, adding that income funds or stocks with a reasonable dividend yield looked attractive.
MACRO HEADWINDS
Credit Suisse, which has just taken its equity weightings down to benchmark from overweight, says falling equity valuations, still high corporate default rates and macroeconomic uncertainty give reasons to be cautious on stocks now.
"We believe the downside and upside risks to equities are now quite symmetrical," the Swiss bank says.
"The recent rise in bond yields is worrisome ... We believe we are in a range trading market like the 1970s."
The two-year U.S. Treasury yield rose as high as 1.37 percent on Monday, levels last seen in early November. It jumped 34 basis points on Friday, its biggest single-day rise since September, and contributed to the largest weekly jump in the benchmark 10-year yield in about six years.
Credit Suisse is also cautious about net new equity issuance in the United States. It says this has risen to an all-time high at 2 percent of market capitalisation, and when corporate net selling of stocks was 0.35-1.15 percent of the market, the S&P 500 index has on average fallen by 3.3 percent in the following three months.
Neil Woodford, head of investment at Invesco Perpetual, says lingering downside risks in the economy mean investors should focus on companies that have stable business models with low volatility of returns.
"The problems that led to this recession, problems of excessive leverage in the consumer economy, excessive leverage in the banking system, have not been corrected at all," Woodford said.
"The start of a new business cycle, the start of a period of sustained expansion in the economy, is a hell of a long way away -- I believe three or four years away. That's why I'm of the view that there is a lot of risk now in markets."
CREDIT LEADS
The performance of credit markets is also key, especially in the high-yield sector which some say leads equities by around two months in a bear market.
One of the biggest drags on the credit market is the high level of corporate bankruptcies. Credit insurer Euler Hermes forecasts a 35 percent increase in corporate worldwide insolvencies for 2009, after a rise of 27 percent last year.
And the commercial paper market -- which was hit severely after the credit crisis -- is still contracting. According to Goldman Sachs, the CP market has contracted by $385 billion since the beginning of the year, which partly reflects the fact that the securitisation market may take more time to correct.
The high-yield market might now be showing some signs of fatigue after the average price of high yield debt rose $23 from mid-December's all-time lows and the spread tightened by 10 percentage points, according to calculations by Barclays Capital.
"While we maintain our positive view on high yield valuations, the tightening certainly takes some of the upside away, and given our expectations for continued volatility, we believe the improvement will not progress in a straight line," Barclays Capital said in a note to clients. "Better entry points may appear in the near future."
(Editing by Ruth Pitchford)