Hamish McRae: Why signs of a recovery haven't cheered the markets

The significance of Enron was to make people question corporate America's previous accounting for profits

Is there a turning point in the world economy at last? The past three for four weeks have seen a curious switch in market sentiment worldwide: people have become more optimistic that the recession, such as it was, is either over or will be relatively short-lived everywhere except Japan. But meanwhile share and bond markets, which had previously been reasonably cheerful, have become more concerned about the future.

There is a one-sentence explanation to this. The economic figures seem to show a turning point has been reached, but the Enron scandal has undermined confidence in business balance sheets. But that explanation itself leads to new and disturbing questions.

The evidence of the turning point first. The top two charts here, one showing the expectations of US manufacturers, the other of German industry, both show turning points. The upswing is much more marked in the case of the US, of course, but you can just see the German Ifo index perking up too. These are not perfect indicators of what will happen to the two economies but they have a good long-term record.

In the case of the US (though not yet Germany) there is a lot more evidence of at least a bounce in actual output, not just expectations. This is particularly clear in the hi-tech industries: things like chip production, telecoms equipment and so on. In fact, the US hi-tech industries, having pushed America into recession, now seem to be pulling it out.

Worry about the US consumer suddenly cutting back? In theory that has to be a serious concern but in practice there is no evidence of that. Indeed, the very latest figures show a slight perking up in consumer sales after a quieter couple of months. Of course it is all on tick and at some stage consumers will have to rebuild their savings. But provided they do so slowly, the US could be able to grow its way back into balance.

What about Europe? Sentiment in the eurozone seems to be improving, with France in particular looking better. Should one worry about the still-rising unemployment in Germany? Not really, unless you happen to be German and losing your job. Unemployment is a lagging indicator and in Germany has more to do with poor labour market policies than a general lack of demand for the country's products. German exports are at the moment doing rather well. Yes, there are real concerns about the eurozone's medium-term competitiveness, but in the short term things are picking up.

In short, a clear bounce is taking place and rather earlier than the market expected. The optimists seem to be right. So why the new gloom?

The reason is that the optimistic view which ruled the markets since the end of last September has been proved right in economic terms but wrong in financial ones. You could justify the bounce in share prices if economic recovery, plus slimming down of companies, lead to a rebuilding of profits. The significance of Enron was to make people question corporate America's previous accounting for profits. There don't have to be further catastrophes on the scale of Enron to unsettle things, if thanks to lax accounting corporate America's profits have been overstated by, say, even 15 per cent.

There will undoubtedly be further profit shortfalls in past published accounts for the auditors are running scared. When accountants are scared, they crawl over figures to make absolutely sure that they are covering their backsides. Even if they can manage to explain past accounting practices, expect their change of mood to be reflected in poor reported profits in the future. And while accidents like the speculative losses at Allied Irish Banks may not be significant in world terms, they further upset sentiment.

Of course the danger of all this is that, despite the recovery of the world economy, financial markets will be hit by a series of blows, which will feed back into lower consumer and business confidence and abort the recovery.

If the overstated profits of US companies are the most obvious risk, there are others. Next must come some kind of collapse in Japan. This has been such a long time a-coming that it is tempting to stifle a yawn when it is mentioned. But last week saw the Nikkei and the Dow crossed over for the first time since 1953, yup, 1953. Prime Minister Junichiro Koizumi has lost much of his popularity. Dangerously for hope of reform, Mr Koizumi is facing the charge that he is just a pretty face who doesn't understand economics and therefore is unable to push through banking reconstruction. The connection with the Nikkei is that the further shares fall, the worst the banks' balance sheets: they are even more bust than they were.

Meanwhile popular dissent in Japan is being fuelled by job losses, which are rising inexorably. As the bottom left graph shows, employment is falling at a rate of more than 1 per cent of the workforce a year. Unemployment in Japan is now 5.6 per cent, the same as the US. But socially this is much harder for Japanese people to cope with.

In any case, as the economy recovers, it will become clear that the bottom of the interest rate cycle is near. Some time in the next few months the first tentative steps in interest rate rearmament will be taken: rates will nudge up. There are all sorts of views about when and where the first rise will take place but wherever it is, consumers are hardly prepared. The bottom right graph shows what has been happening to personal borrowing here, rising by more than 10 per cent year on year. That is much faster growth than incomes. Debt service is not a problem while rates remain low, but when they rise...?

Many commentators, looking at the contrast between the clear bounce and these murky clouds on the horizon, conclude that there is likely to be a double bottom to the cycle. A dip now; a recovery in the spring; another dip in the autumn.

Of all the various projections around that is probably the most sensible one to have in the back of the mind. It is certainly my own "most likely" outcome. But beware the false precision. Don Straszheim, an independent economic commentator over in California (and a former chief economist at Merrill Lynch) makes the wise point in his latest newsletter: "the seers do not know".