The markets are "trading more stable" or so it seems, although volatility has given up little (VIX is still near 30 points). By the way, there are things to rescue this week, such as the recovery of European banks that somehow alleviates fears that in addition to the energy crisis we are facing today, we could potentially have faced some kind of "financial crisis" regarding how the economic sanctions on Russia could have generated some "disruptions in the financial markets". Additionally, the fall in commodity prices in the face of growing optimism that a ceasefire agreement might be possible in Ukraine also generates some sense of relief.

The question that follows then is that if we have already seen the worst in terms of market adjustments?

At the beginning of the year, we argued that the markets could be facing some kind of "mean reversion" in terms of valuations and a "4Q18 style" adjustment, which was attributed to a "policy error" by the FED(https://www.fynsa.cl/newsletter/una-clasica-historia-de-reversion-a-la-media/).

Recently, we argued that focusing primarily on geopolitical risks could divert attention from what is really important in the markets today, that is... runaway inflation and the dilemma central banks face in terms of balancing downside risks to growth and upside risks to inflation exacerbated also by the geopolitical crisis in Ukraine. ( https://www.fynsa.cl/newsletter/que-los-arboles-no-le-impidan-ver-el-bosque/ )

Markets have their "codes", even if they do not have much fundamental support. For example, the definition of the bear market limit is limited to a market drop from highs to lows of 20%, anything below that is only understood in a context of "crisis" and recession. Therefore, it seems no coincidence that the fall of the Nasdaq and other markets such as Europe, for example, has been limited to 20% levels. However, at a more aggregate level, the S&P 500 and the MSCI World show a more limited fall of around 10%, which qualifies as a "classic correction".

From here several questions arise... could this be the end of the market correction? How will we know when it is over? And do we run the risk of a bear market? During the week Gavekal published a study that gives some clues and that seems to me to be accurate.

Looking back at the bear markets of the past decades: the Asian crisis, the dotcom crash, the mortgage crisis, the euro crisis, the Chinese stock market crash of 2015, the Christmas massacre of 2018, the Covid panic of 2020, it is possible to say that bear markets come to an end when one or more of the following events occur:

1. Central banks, especially the Federal Reserve, flood the system with money. This is what happened in 1998 after the LTCM crash, in 2001 after 9/11, in 2008, 2018 and most recently two years ago in March 2020. Clearly, once central banks step in and say "don't worry, we've got your back," equity markets are prone to bounce.
2. Oil prices collapse. Rising oil prices are a major drag on global liquidity. Financing the world's energy needs is extremely capital intensive; the higher the cost of energy, the greater the amounts of capital needed to finance the world's energy inventories. Similarly, falling energy prices free up excess capital, which can be put to other, perhaps more speculative, uses. A major collapse in energy prices, as in 1997-98 during the Asian crisis, or in 2020 with the Covid panic, may help global stock markets find their equilibrium.
3. Long-term US Treasury yields collapse. A collapse in long-term yields is a sure sign that markets are in the midst of panic. The resulting low yields (i) encourage central banks to relax and (ii) make all other assets more attractive on a relative basis. Most investors are looking for a minimum return when they put their capital at risk. If they can get that return by buying government bonds, why do anything else? But when potential bond yields are too low, investors must take on more risk, whether in corporate bonds, stocks or other risky assets.
4. Valuations become irresistibly attractive. Perhaps the healthiest way for a bear market to end is simply for stock valuations to become so compelling that they attract waves of fresh capital, whether domestic or foreign. This is what happened in Asia after the Asian crisis and in Europe after the euro crisis. In essence, the equity risk premium is so high that anything short of absolute Armageddon almost guarantees attractive compound returns over the long term.

So, back to the original questions: Are we in a bear market? And could it be ending? On the face of it, it doesn't appear that any of the four conditions for a market bottom are close to being met.

• With inflation at 7.5% in the US and 5.8% in the Eurozone, it seems unlikely that Western central banks will flood the system with new liquidity any time soon. If they do, they will run the risk of being accused of bailing out wealthy investors at the expense of the real incomes of ordinary households. The only major central bank that is easing today, and for the foreseeable future, is the People's Bank of China.
• The Ukraine war and resulting sanctions against Russia mean that energy markets will remain tight for the foreseeable future, or at least until high oil prices break the global economic cycle, which would hardly be great news for asset prices.
• Despite geopolitical risks and rapidly falling equity markets, long-term U.S. bond yields have barely retreated, even rising again, as inflationary pressures become more evident.
• Valuations in most equity markets are still far from "sufficiently attractive" levels. Global equities would have to adjust by an additional 10% to converge to long-term averages (see attached chart 1).

In short, markets appear to remain vulnerable to further adjustments. If geopolitical tensions subside, concerns will refocus more strongly on inflationary risks and policy tightening. Global financial conditions have become tighter (see attached chart 2).

In any case, our base scenario does not consider recession risks, at least not in the US and with China applying a supportive policy, we believe that, except for Europe, recession risks are still limited today, therefore , we believe that conditions for a "bear market" are not in place . So any further adjustment should be interpreted as a buying opportunity in global equities.

Humberto Mora

Strategy and Investments