Could this week’s move by global central banks to nudge up interest rates be the prelude to a global sharemarket sell-off?

Overnight, the European Central Bank responded to growing inflation pressures by lifting its main interest rate by 25 basis points to 1.5%, the second such hike this year. ECB boss Jean-Claude Trichet pointed to”upside risks” to inflation, and the danger of price pressures becoming entrenched.

The ECB’s decision follows China’s move earlier in the week to raise interest rates for the fifth time in eight months. Chinese leaders are worried that rising prices are fuelling growing social unrest. China’s inflation rate has averaged more than 5% this year, and some economists predict that inflation figures due out next week will show that China’s inflation rate climbed above 6% in June, the highest level in three years. China’s inflation is being fuelled by double-digit increases in food prices, which hit lower-income families the hardest.

Some analysts worry that rising global interest rates will provide headwinds for sharemarkets. They point out that global equity markets generally record strong gains when global interest rates are falling, but tend to falter when central banks start tightening policy.

Societe Generale’s Albert Edwards, however, has a different take. He warns that sharemarkets could come under intense pressure from a slowdown in the global economy, rather than central bank tightening.

In his latest report, Edwards warns that in the lead-up to the latest earnings season, companies are up to their usual trick of “guiding” analysts’ estimates down, so that they can then surprise the market by reporting earnings that beat this lowered bar. But, he warns, “the recent spate of profit warnings — which have resulted in a deeper-than-normal round of downgrades — may be the beginning of something far more undermining to equity prices over the next six months”.

Edwards points out that analyst optimism has been ebbing since May, but has fallen even more sharply in recent weeks. What’s more, he says, changes in analyst optimism tend to be a lead indicator for conditions in the economy. Their current downbeat mood suggests that the global economy could be on the verge of a slow-down.

Edwards argues that in post-bubble economies, sharemarkets are much more vulnerable to weakening economic conditions.

“Studying Japan a decade ago we came to the conclusion that in a post-bubble, Ice Age world, the equity cycle and economic cycle become unusually synchronous. Prior to that bubble bursting, the equity market enjoyed a closer positive correlation to bond prices than the profits cycle.” In addition, in this pre-bubble world there was a secular trend for price/earnings ratios to expand, driven by lower bond yields.

But this relationship changes in the deflationary world that follows a major credit collapse, where there is still an excessive overhang of debt overhang, and where the private sector is intent on deleveraging. In this post-bubble world, the equity market follows the economic cycle, but in an exaggerated fashion.

According to Edwards, “in the Ice Age, the secular trend sees equity price/earnings ratios contract, despite lower bond yields. The secular trend of price/earnings contraction intensifies ferociously during economic contractions.”

*This first appeared on Business Spectator.