Sharp gains in share prices on both sides of the Atlantic despite worldwide financial turmoil could leave stock markets vulnerable to a painful correction, the Governor of the Bank of England told investors yesterday.

As he predicted “many more months of stress in financial markets”, Mervyn King raised a question mark over the fact that even as credit markets have been rocked by the sub-prime home loans crisis in the United States since August, share prices have continued a steep upward march.

Sounding a warning that these largely unchecked gains in equity markets could leave them exposed, the Governor said: “It’s very striking that despite developments we’ve seen in the last three months, equity prices are on average higher now than they were in August.

“This is true around the world, and in emerging markets they [share prices] are 20 per cent higher. There must be some downside risks there . . . That’s the bigger risk to the world economy.”

As he unveiled the Bank’s latest quarterly Inflation Reporton prospects for the economy, Mr King expressed surprise that a long-awaited “repricing of risk” across the financial world “has not really fed through to markets such as equity markets”. He cautioned that if investors suddenly reassessed risk exposures and demanded a higher premium for holding the extra risk associated with equities, “then that could have a bigger impact on the world economy”.

Mr King’s apparent wake-up call over equity markets came as he admitted that it was hard to gauge the full impact of the credit squeeze, with any assessment fraught with uncertainty. He said that the shock-waves from the shake-out in credit markets could take months to fade away, although he predicted that an end to the turbulence should be in sight by the second half of next year.

The Governor also played down the risk of lasting damage to financial stability and confidence from the near-collapse of Northern Rock and forecast that present anxieties would ease by next year.

He said: “We still have many more months of the stress we have seen in financial markets, but this will be gradually worked through by the middle of next year, although there is a great deal of uncertainty and fragility still there. Once we get through that, people will look back and realise that the structures are sound and the economy will come through.”

After heavy criticism from the City since August over the Bank’s controversial strategy for managing the stresses in Britain’s markets for lending between banks, Mr King defended its actions. He said that the Bank’s chief aim was to ensure that overnight lending rates between commercial banks were kept in line with base rates and insisted that it had been at least as successful as the US Federal Reserve and the European Central Bank in achieving this.

“Other central banks are also grappling with it,” he said. “Overall, we will be looking at our money market operations, but we feel they work extremely well.”

He urged that severe losses sustained by leading banks because of the toll from the credit squeeze on debt securities and off-balance-sheet vehicles should be kept in perspective. But he admitted that strains on banks’ finances as a result would adversely affect the economy as they resorted to toughening their loan conditions.

In its report yesterday, the Bank said that, over the medium term, it expected the credit squeeze to mean a rise of a quarter of a percentage point in the typical interest rates faced by companies and individuals because of tighter lending standards.

Mr King said that Britain’s banks were well placed to absorb the impact of the losses that they have suffered because these were still small relative to the huge profits made in the past three years during a financial boom, as well as against banks’ overall capital.

He noted that Britain’s “big five” high street banks had made profits of about £100 billion over the past three years. He added: “If there was ever a moment for it to be helpful for banks to be making such large profits, it must be now, because they will provide the cushion that will guarantee the stability of our banking system.”

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