Morgan Stanley predicting correction By Ambrose Evans-Pritchard Last Updated: 1:10am BST 24/07/2007 Morgan Stanley has warned that current jitters on the global credit markets could spread to equity markets. Stock market corrections - after an increase in the cost of debt - historically follow six months later, suggesting that the current rally on Wall Street and European bourses may be more fragile than it looks. Wall Street sign, Morgan Stanley predicting correction The current rally on Wall Street and European bourses may be more fragile than it looks A rise in the interest rate spread between risky debt and benchmark treasuries knocks away a key support for share prices by raising the cost of money for leveraged buyouts, but there is often a long delay before investors react. A study by the bank found that credit spreads began to widen on average six months before every stock market correction of 10pc or more over the past 20 years. The current widening began in February, picking up speed over the past three weeks. If history is any guide, this could point to a global stock market slide as soon as August. Morgan Stanley's model suggests a 14pc fall, or 2,000 points off the Dow. "This is not the first time that equity markets take their time to react to bad news," said the bank's chief Europe strategist, Teun Draaisma. "The fundamentals have deteriorated. Equities have reached all-time highs despite higher rates, wider spreads, higher oil, Chinese tightening, and a stronger euro. "There is a widespread belief in continuation of good global growth without inflation. While we are not expecting a recession for another two to three years, we believe chances are high that this belief will be seriously tested soon." advertisement Mr Draaisma added that ever clearer signs of "stagflation" would soon start weighing on confidence. The current pattern looks similar to the relentless rise in spreads from February to September 2000 when the stock markets finally tipped over. Mr Draaisma said the iTraxx Crossover index measuring risk appetite for high-yield bonds touched bottom at around 170 in February. It has since jumped to 320 - mostly this month - implying at 150 basis point rise in the cost of raising capital. Morgan Stanley said the trigger for a stock market fall could be a sudden unwinding of yen "carry trade" from Japan, a major source of global liquidity. The Bank of Japan in expected to raise rates a quarter point to 0.75pc in August. The worst stock market falls have been -58.4pc after the dotcom bust, -34.3pc in October 1987 and -30.8pc in a two-month shake-out after Russia defaulted in 1998, as measured on the MSCI Europe index. Morgan Stanley said its "value indicator" shows that the median stock in Europe is now selling at a record high price-to-earnings ratio of near 20. This measure includes smaller and mid-size companies. The price/earnings ratios on big blue-chip companies are much lower, hence the widespread belief that stocks are "cheap". Mr Draaisma's study found that worst performing stocks at times of widening spreads are financial and industrial groups. Among the worst losers in previous bouts have been Man Group (-39pc), Swedbank (-38pc) and Barclays (-35pc). The best defensive stocks have been consumer staples such as Carrefour (+41pc), Unilever (+41pc) and Nestle (+39pc). http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/23/cnmorgan123.xml