This Is What Could Knock Euphoric Global Markets

Growing optimism about the economic outlook and a string of upbeat earnings has put global equity markets on a strong footing at the start of the year.But hold on, say strategists, pointing to a risk that investors are underestimating: a U.S. budget sequester.

Put simply this is a policy procedure adopted by Congress to deal with the budget deficit and is a way of forcing spending cuts. Analysts say the sequester implies about $1.2 trillion worth of automatic spending reductions in departments such as defense and is due to kick in on March 1 unless Congress stops them.

"If it (the sequester) goes through it would have a 1 percent drag on GDP (gross domestic product) and unemployment will go up," Tony Nash,managing director at IHS Consulting told CNBC Asia's "Squawk Box" on Monday.

"If the sequester kicks in and some other tax issues kick in,you're also looking at about 1 percent being added to unemployment, so you're looking at a lot of risk in the first half of the year," he added.

The U.S. unemployment rate is 7.8 percent, with the latest monthly job numbers due this Friday.

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Judging by the latest comments out of Washington, the sequester is a real risk. "I think the sequester is going to happen," House Budget Committee Chairman Paul Ryan told NBC's "Meet The Press" on Sunday.

In addition to this, talks about raising the U.S. debt ceiling are still due to take place, so U.S. fiscal woes may resurface, threatening to take the edge off a stellar rally in global equity markets, analysts said. There was some relief last week after U.S. lawmakers approved an extension of the debt ceiling.

The S&P 500 stock index crossed the key 1,500 level on Friday, logging its longest winning streak since 2004. Stock markets in Europe have rallied 3.5 percent so far this month, while Japan's Nikkei stock index climbed to a 32-month peak on Monday above 11,000.

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"There's the sequester, the continuing (budget) resolution talks, the debt ceiling, so there is serious risk in the U.S. in the months ahead," Nash said.

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Weighing Up Risk

It's a view that analysts at Barclays shared, adding that concerns about U.S. fiscal woes were a reason not to expect government bond yields to rise too sharply, as some analysts expect.

Yields on benchmark Treasurys have added about 20 basis points so far this month as investors shift out of safe-haven debt and into riskier assets amid a backdrop of brighter economic data in the U.S. and China, the world's two biggest economies, and fading concerns about the euro zone debt crisis.

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"Risky assets have staged an impressive rally this year on the back of positive global sentiment with risk premia compressing sharply," the Barclays analysts said in a note on Monday. "By late February, however, we expect rates (yields) to start grinding lower… in part on a more realistic assessment of the fiscal drag likely to prevail in the latter half of the year and beyond."

According to Barclays, because of little appetite by U.S. lawmakers to delay spending cuts further, U.S. economic growth forecasts for the second half of the year are likely to be revised lower.

"We also believe that the market is underestimating the extent of the fiscal drag likely to prevail over the next few years," Barclays said.

Pull Back, Just That?

For some analysts global equity markets, battered by the global financial crisis,have now turned a corner and any disruption that worries about the U.S. budget position bring are likely to be temporary.

"It is probably time for a pull back, but I think we are at the start of a significant long-term move," ABN Amro chief economist Han De Jong said.

Steve Brice, chief investment strategist at Standard Chartered Wealth Management Group in Singapore said the key for investors was not to miss the boat as risk appetite returns to global asset markets.

"We do have the debt ceiling talks coming up and if you get any weakness from that, then you should take it as an opportunity (to get back into stocks)," he told CNBC. "If we get through the debt ceiling talks, maybe we could see some more confidence coming through from the U.S. corporate sector," he added.

- By CNBC's Dhara Ranasinghe; Follow her on Twitter: @DharaCNBC