By Natsuko Waki
LONDON, June 26 (Reuters) - As world stocks wrap up what is likely to be the best quarter in at least two decades next week, tests of the sustainability of a rally in risk loom for global financial markets. The onus of proof is on economic data, including closely-watched U.S. jobs figures next week and quarterly earnings from major companies, as investors seek reassurance on betting on an improved outlook in the new quarter.
World stocks, as measured by MSCI <.MIWD00000PUS>, have risen more than 20 percent as the second quarter draws to a close. That would be the biggest three-month gain in the history of the index, which was launched in 1988.
Credit markets have also rallied, with investment grade
corporate bond yield spreads, measured by the Markit iTraxx
Europe index
But the rally since mid-March has been showing signs of fatigue pushing markets into trading sideways, and this stalemate may not last long.
"Equities have gone one way until recently and you have to question the validity of it. The validity and integrity have not been stress-tested," said Paul Morgan, chief executive officer of Conduit Capital Markets.
"The story for the third quarter will be played out over the next month or so. We are looking for validation of economic growth and whether requirements for additional risk can be validated. We are in an inflection point. We cannot maintain this for a long time. Either we validate the story or destroy it."
FLOWS OUT
Latest fund flows show investors scaling back on their recent foray back into riskier assets.
In the week to June 24, investors pulled a net $1.87 billion out of Asia ex-Japan, Latin America, emerging Middle East and African and diversified global emerging markets equity funds, according to fund tracker EPFR Global.
Doubts about the timing of a recovery in the global economy also hit equity funds, which lost $4.12 billion for the week, snapping seven straight weeks of inflows.
Investors parked the cash in safe-haven money market and U.S. bond funds instead, EPFR said, noting these funds had absorbed $25.9 billion and $1.72 billion respectively.
A quarterly survey by HSBC found that global fund managers had become less optimistic about equities, with 40 percent of respondents going underweight equities in the second quarter, compared with 22 percent in the previous three months.
HSBC's survey, covering about 13 percent of global funds under management, also showed views towards bonds remained bullish quarter with 7 in 10 fund managers holding overweight views, versus 57 percent of respondents in the last quarter.
"While investor confidence has slightly improved, investors remain cautious about the continued uncertainty in the global economy," Bruno Lee, HSBC's head of liabilities business and wealth management in Hong Kong, said in a note.
"There is still a flight to quality amongst investors with capital preservations being upper most in their investment priorities until more certain long-term growth prospects emerge in the global economy.
Another potential source of stress for markets comes from emerging markets.
Bond repayment pressures are building in emerging Europe as borrowers -- both corporate and sovereign -- struggle to meet scheduled coupon repayments in the face of weaker economies and currencies.
Corporate and sovereign bond repayments are expected to top $21 billion in Turkey and $10.8 billion in Russia for the third quarter alone, according to Thomson Reuters data.
While the bulk of Turkey's $20.8 billion sovereign debt maturing in that quarter is denominated in its lira currency, about 40 percent of the $2.8 billion maturing bonds faced by Russian corporate borrowers is denominated in U.S. dollars.
CREDIT RECOVERY
Less risky credit markets may fare better, just because of the sheer scale of pessimism which had been built into prices.
Barclays Capital's model anticipates close to 100 basis points of spread narrowing in investment grade credit over the rest of the year.
"The Q2 recovery wasn't it. There will be more steam coming in Q3," said Tim Bond, head of asset allocation at Barclays Capital. "As far as we can see the recovery is on track. In the next two to three quarters, the market is pricing in what we see as (a) reasonable sustainable recovery."
"We advise clients to be well above the benchmark in credit and equities."
As for stocks, Barclays believes prices do not yet fully incorporate the probable near-term rise in profitability and expects main equity indexes to rally another 20 percent during the next 3-4 months.
"In August and September we can go sideways but it's a big risk to take risk down now. You should start to get longer after August and September," Bond said.
(Additional reporting by Sebastian Tong)