Risks to global equity rally

Four major risks threaten a solid year-end rally to cap this year's stunning bounce back by global equities -- earnings, bonds, currencies and cash.

Investor optimism has been so unrestrained recently that good earnings are beginning to be dismissed because they do not meet exaggerated expectations.

Take Goldman Sachs (GS.N) this week, for example. It beat earnings expectations by 23 percent on a per share basis but the announcement was met with disappointment.

Stocks fell and the dollar rose initially when the results came out because the market was so ebullient it was willing to believe a so-called whisper number for the earnings at the wildest edge of speculation.

In the event, stocks recovered to close higher on the day. But disappointments were the order of the day on Friday.

Nonetheless, world stocks begin next week at 12-month highs, up well over 70 percent from their March lows. High-yielding currencies are in huge demand and emerging market debt spreads have narrowed about half a percentage point in October alone.

Underlining it all, measures of the volatility of Wall Street stocks are falling. The VIX volatility index .VIX, the fear gauge, has broken below its recent range and is now at normal, pre-crisis levels.

This all points to risk-hungry investors entering a new week with the bit between their teeth again, despite the odd disappointment such as Friday's Bank of America (BAC.N) loss.

Earnings turned in the second quarter of this year. We are on track for a good 18 months of corporate earnings growth, said Bob Parker, vice chairman of Credit Suisse's asset management arm.

The market is enjoying high levels of liquidity, a store of investor cash and generally positive economic numbers, he said.

Underlying economic numbers such as Chinese trade and lending, UK unemployment, U.S. retail sales and euro zone manufacturing have come in better than expected.

Reuters polls this week found expectations among economists that the U.S. and euro zone economies came out of recession in the third quarter.

RISK APPETITE

There are, nonetheless, the four risks. Much of the latest tranche of the stock rally is based on optimism over earnings.

Notwithstanding Goldman's failure to meet excessive expectations and the Bank of America results, many reports have been positive, among them JPMorgan Chase (JPM.N), Google (GOOG.O) and IBM (IBM.N).

Thomson Reuters Proprietary Research shows that as of Thursday, with 10 percent of S&P 500 index .SPX companies having reported, 82 percent had beaten expectations.

Should many others come in below forecast or expectations rise too high Goldman-like, the market would be vulnerable to a quick reversal.

Retailers will be in focus next week and Europe will have its first full week of reporting. Results are due from Apple (AAPL.O), Nestle (NESN.VX), Danone (DANO.PA), Coca-Cola (KO.N), Cadbury (CBRY.L), Hershey (HSY.N), LVMH (LVMH.PA), PPR PPR.PA, Ahold (AHLN.AS) and Home Retail (HOME.L).

Government bond yields, in the meantime, have been rising modestly this month as equities have gained and risk appetite built up. The risk is that this becomes more rapid, creating a sell-off that would send borrowing rates through the roof.

The factors mitigating against this are continued low rates and quantitative easing from central banks along with muted inflationary pressures.

This leaves markets highly sensitive to any hint that authorities are seeking to exit from the programmes the set in place to combat the financial crisis. Australia, for example, has already begun raising rates.

PARITY

All eyes next week will also be on the currency markets where the dollar's overall decline has begun to concern those countries whose currencies are rising as a result.

If we have dollar/euro going to $1.60 very quickly that would put a big constraint on euro zone economic recovery, likewise the yen at 85, Credit Suisse's Parker said.

The dollar was a fair way from these levels on Friday, at around $1.49 to the euro and 91 yen -- but the fact that these levels are being mentioned shows the sentiment toward the dollar.

It has fallen 6.6 percent against a basket of major currencies this year.

Parity, meanwhile, is drawing nearer for the U.S. dollar/Canadian dollar, dollar/Swiss franc and euro/sterling. The psychological impact of hitting such rates would magnify the official reaction, exporters' scramble to hedge, and the complaints about loss of competitive advantage.

Finally, there are signs that the tidal wave of cash that was put into money market funds at the height of the financial crisis has now mostly been thrown back into other assets this year.

The latest outflows from money market funds took the YTD total to $396 billion, equal to nearly 94 percent of the total weekly inflows recorded by this fund group during 2008, Fund trackers EPFR Global said this week.

(Additional reporting by Swaha Pattanaik; graphic by Scott Barber; Editing by Toby Chopra)