Equities will rise in coming months as US companies boost record levels of free cash flow, but the third quarter of 2011 could still be turbulent, says Merrill Lynch Wealth Management.

The main reason for optimism is that the forces behind the slowdown of the economy in the previous quarter are likely to be reversed, which was demonstrated in the last week of June.

Merrill Lynch describes the first half of the year as “treacherous”, but one that ended on a high note. At 5.6 per cent, the conclusion of the first half saw the biggest one-week rally in the US equity market since mid-2009. The positive trend is believed to be a sufficient bulwark against a return to a “risk-on” phase in the next six months.

The overall situation in the US is brighter than May’s unemployment figure of 9.1 per cent suggests, Merrill says. Corporations hold healthy balance sheets and equity valuations remain compelling, but up to now, the strong sentiment in favour of higher capital expenditure has not led to real activity. Merrill Lynch anticipates the gap to close in H2.

What can cause instability are risks in the political arena. However, Merrill believes we could be in for a positive surprise if the Democrats and Republicans can agree on a deficit reduction plan as part of the forthcoming debt ceiling negotiations, which would support a stronger dollar.

The firm also sees the growing sense that China has defeated the inflationary demon, coupled with advancing industrial metals and an expected fade in higher oil prices, as hints of a stronger second half for emerging market equities.

Natural disasters in Japan, the war in Libya and unrest across the Middle East and Africa, and fears over emerging market inflation turned the first half of 2011 into a bumpy ride, and undermined efforts to shed debt across the developed world. The recovery was hit by sluggish business investment and soaring oil prices, the firm notes.

In US dollar terms, emerging market equities have fallen 0.4 per cent and Asian equities increased 0.5 per cent, under-performing the 4 per cent rise in developed market equities.

The Greek Parliament’s approval of the austerity measures needed to secure another euro bail-out, and promising economic data exemplified by the rebound of Japanese manufacturing are believed to be important developments behind the positive trend. Japan is now back to the levels it had before the earthquake and tsunami-catastrophe in March; the 5.7 per cent industrial production rise in May is expected to be repeated in June. We are yet to see what impact the electricity restriction introduced on 1 July will have, says Merrill.