Stock markets worldwide will reflect the battle between two contradictory forces this year û earnings downgrades and cheap valuations, Citi notes in a global equity strategy report.

ôWe think that cheap valuations should win out and drive the global equity market up by around 10% in 2008, but it will be a volatile ride,ö Citi says.

Under this assumption, Citi is overweight in emerging markets and in Europe ex-UK. Positive earnings momentum, a strong earnings outlook and low real interest rates keeps Citi bullish over emerging markets, where it prefers cheap markets such as South Korea and Taiwan over those that have been on the rise such as China and India. Cheap valuations and a reasonable growth outlook make Europe ex-UK CitiÆs favorite developed market.

Citi is underweight in the US and in the developed Asia-Pacific markets of Australia, Hong Kong, Singapore. It is most bearish over the US among major regions and remains its key underweight because it sees more interesting opportunities elsewhere. The developed Asia-Pacific markets look expensive, suffer from poor earnings momentum, and may run into declining levels of excess liquidity due to high real interest rates, it says.

Sector-wise, it is overweight in industrial cyclicals and generally underweight consumer sectors.

Citi notes that any expectation of corporate earnings will depend significantly on the outlook for the global economy, and the challenges remain significant.

US housing and financial stresses will prove a drag on the global economy and crude oil prices have reached levels previously associated with recession. But Citi economists think that the sources of resilience remain significant û specifically, economic leadership from the emerging economies, and the prospect of global monetary easing.

The developed industrial economies are expected to slow to a lacklustre but not catastrophic 2% real GDP growth in 2008, Citi says, adding it forecasts continued strength from the emerging economies at a real growth of 6.9% over the next 12 months.

ôOur forecasts suggest that the emerging economies should be able to digest a typical mid-cycle slowdown in the developed economies. However, a shift into recession among major economies would prove much more troublesome,ö Citi says.

CitiÆs economists are not strong advocates of the decoupling thesis.

Citi expects to see a meaningful slowdown in the US economy in the first half of this year. It remains concerned about the housing markets and worsening US and European financial conditions.

However, Citi notes that a reasonable inflation backdrop gives the US Federal Reserve the scope to ease monetary policy further. ôOur economists suggest that this should be enough to buffer the healthier segments of the US economy and support fragile investor confidence.ö

The general picture is of a world economy ômuddling throughö in 2008, Citi says.

While mindful of the risks, Citi economists do not expect the US to fall into recession and drag the world economy into the mire.

ôIf that view is proven right over the next 12 months, then we would expect global equity markets to perform well enough. However, nervous investors will take some convincing,ö Citi says. ôIn particular, we suspect that markets will remain fragile while GDP predictions are being downgraded.ö

Meanwhile, Citi says the vulnerability of current consensus forecasts for earnings represents the greatest challenge to equity markets in 2008. It notes that acceleration in global earnings growth seems incompatible with the slowdown forecast for the world economy. It would expect global corporate earnings growth nearer nominal GDP growth of 5-6%, well below the current 12% consensus bottom-up forecast. It's topdown forecast also suggests that profit margins, already at record highs, are unlikely to make further progress.

ô2008 is likely to be the first meaningful earnings downgrade year since 2003,ö Citi says.

Citi notes that global earnings growth expectations for 2007 peaked at around 11% back in September before downgrades took the forecast back below 10%. The reduction in forecasts can be blamed on the developed markets, and US financial stocks in particular. By contrast, emerging markets continue to enjoy upgrades.

Citi notes it is easy to see why the recent shift towards earnings downgrades makes equity investors so nervous, but the longer term relationship between earnings revisions and market performance seems less clear.

With the exception of 1994, analysts started each year of the 1990s with overly optimistic earnings expectations, but that did not stop the global equity market from making impressive annual gains through the decade, Citi says. Two of the worst years for downward revisions û 1991 and 1998 û saw equity gains of 15-20%.

ôWhile we estimate that the global consensus is still 6% too high for 2008 earnings, it appears that this may not be enough for us to take a bearish view on the global equity market,ö Citi says.

The global stock market has risen by 140% since 2003. Equity investors have profited from strong earnings growth and cheap valuations over the period. But 2008 will be different, Citi says, because while valuations still seem cheap, the earnings outlook is much more uncertain.

ôIt is this twoûway tussle that will set the direction of global equities over the next 12 months,ö Citi says. ôThe bears will point to the credit crunch, recession risks and over-optimistic earnings expectations. The bulls will point to cheap valuation and the prospect of further rate cuts.ö