Stocks will see a 20 percent correction at the start of 2015 as the U.S. Federal Reserve begins to raise interest rates and investors feel the effects of a world without cheap money, one strategist told CNBC.
The Fed is set to end its massive bond-buying program in October – a policy that has been blamed for fuelling rising stock prices over the past few years. At the same time, analysts are expecting the U.S. central bank to introduce its first interest rate hike since 2006.
All eyes will be on Fed Chair Janet Yellen next week when she delivers a highly anticipated speech at the annual get-together of central bankers in Jackson Hole. While the market expects her to remain dovish – a move supportive of equities in the short term - Michael Gallagher, director of research at IdeaGlobal, said a 20 percent stock market correction would come in the first quarter of 2015.
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"The odds are that we'll see the same broadly dovish message coming from Yellen and that will provide reassurance for the markets," Gallagher told CNBC in a TV interview.
"I think where the problem comes for the markets is when the Fed starts talking about tightening then the underlying economic reality…will come into sharper focus and there's a big market correction. We think that's coming probably Q1 2015."
'Retest S&P highs'
The timing of a U.S. interest rate hike has been thrown into doubt by the mixed messages coming from the U.S. economy. Bumper second-quarter growth of 4 percent in the U.S. was quickly clouded by a slew of weak data. The economy added a less than expected number of jobs in July, while wage growth remained stagnant. Retail sales for July also remained almost unchanged from the month before, pointing towards a sluggish recovery in the U.S.
This has made markets nervous in the short-term but some analysts are not convinced equities will see a major correction because the poor economic data has pushed back the prospect of a rate hike in early 2015.
"If you look at the wage growth and inflation outlook, there is quite some way to go to raise rates in the U.S. and U.K. so I'm struggling to make the case for lower equity markets," Michael Hewson, chief market analyst at CMC markets, told CNBC in a phone interview.
"Given the low interest rate environment and record low yields which are heading lower in U.S. Treasurys, if you want return you have to go into U.S. equities. The likelihood is that we could retest the highs on the S&P."
ECB QE could 'temper' correction
Investors are also keeping an eye on the euro zone economy after GDP figures showed the bloc's largest economy Germany contracting in the second quarter and the single currency area remaining flat.
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The figures sharpened calls for the European Central Bank to begin some form of quantitative easing. While analysts are still split on whether this will take place, any further easing could temper a U.S. stock sell-off, according to Brenda Kelly, chief market strategist at IG.
"If the Federal Reserve hikes rates first I think you'll see a small pull back in equity markets. But if you see stimulus from the ECB that could temper it a bit," Kelly told CNBC in a phone interview.
- By CNBC's Arjun Kharpal