The ink has barely dried on headlines proclaiming fresh highs in European and Asian equity indices. This has not prevented a couple of days of declining equity markets from sparking talk about stagflation.

Hawkish interest rate comments from Federal Reserve officials have unsettled markets, but it is recent equity performance that explains investor sensitivity.

US indices have lagged the rally, but the Nikkei 225, for example, increased by 27 per cent between mid-May and early October. Rising risk appetite has spurred those gains. From a trough in May, CSFB's risk appetite index, which measures the performance of a basket of risky assets relative to safer assets, has risen to a level the bank dubs “euphoria”.

While its markets have benefited less, it is the US economy that remains in focus. The Fed comments come on top of concerns over the short-term negative impact on US growth of Hurricanes Katrina and Rita. The imminent third-quarter US earnings season provides a further excuse for profit-taking, in markets ripe for a correction. Declines in US markets have quickly fed through to other regions.

The sanguine reaction from US bond markets, 10-year yields are little changed this week, suggests that upward pressure on headline inflation is expected to be temporary. But the threat remains of oil-induced, second-round inflation effects. A sharp sell-off in bonds, on higher inflationary fears, cannot be entirely dismissed. In turn, this could reduce discretionary spending by US consumers, already struggling with record fuel prices. Those who fear a more prolonged decline in equities should watch the bond market.

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