Merrill Lynch is cautiously optimistic about recent rallies but warns a great deal more needs to fall into place before it can be safely christened a new bull market, it says in a regular briefing on its investment views.

It cheers the rise equites; April saw the first real optimism that the recession might be drawing to a close and the MSCI World index was up 11.3 per cent over the month. It generated the biggest monthly advances in equity markets in anything from five to ten years depending on the market, building on the recovery underway since 9 March.

Meanwhile, the note warned that the US government's recent deal to protect US automakers will hurt corporate bond-holders, providing a reason for investors to be cautious towards part of this asset class.

The emerging market bloc was the most exuberant, but last month European equities also came to life, Merrill said. Small-cap stocks and the value style were similarly sought out as investors bought into leveraged recovery plays. Credit markets reflected the shift in gear too - Merrill notes a bounce in its global high yield and sovereign emerging debt producing total returns of around 11 per cent and 5 per cent over the month of April, respectively.

Most startling of all, Merrill says, was how limited the damage done to government bond markets has proved to be as deflation fears have subsided. The bank’s UK Gilts index, for instance, produced a small negative return over the month, despite a deluge of red ink around the UK Budget.

Once the current phase has passed, Merrill Lynch says, the waters get a little muddier for those looking for the basis for an ongoing rally. Here the interaction between policymakers’ efforts and easier financial conditions is crucial. There is much yet to be done, but there are some grounds for hope, especially as the cost of capital and finance declines.

Primary markets in certain credit ratings are flourishing alongside stronger equity markets. A big barometer of returning health will be the junk debt market, Merrill Lynch says. Two of the most significant bankruptcies of recent times have forced their way into the news - Chrysler and GM. In both instances, the process has become deeply politicised.

For bond-holders, Merrill notes that the US government of Barack Obama is leaning towards a trade-union friendly solution, at the potential expense of the bondholders. Secondly, following from the first, bondholders are in for a rough ride. The initial offer put before $27 billion worth of bondholders in GM was to dilute the holding down to a 10 per cent equity stake in the new GM.

This offer was due to expire on the 26 May, but has already been countered by an offer from a group of lenders that would leave them with a majority equity stake in the new entity; a distinctly different proposition from the first offer, which would have left the United Auto Workers Union and the US government as the majority shareholders.

At the time of the offer, longer-dated GM bonds were trading between 8 to 9 cents to the dollar. With senior debt holders being treated quite harshly in both cases, drawn-out chapter 11 squabbles cannot be ruled out. The prospect hardly supports a revival of credit flow outside that provided by the spoon of government and central banks.

Even assuming that credit and money flows revive in a meaningful way later this year, investors will still run up against the issue of what exists in terms of underlying demand for credit, at least in the developed economies. The continuing legacy of the credit bubble period is the fact that a number of major economies are saddled with household debt to GDP ratios anywhere between 120 to 180 per cent of GDP.

Merrill says the biggest threat to markets linked to real assets is that a new independent source of demand fails to emerge in Europe or the US once policy has done what it can to underpin activity. If reflationary policy is seen to work however, stand by for concern on inflation re-emerging within the next six months.