The markets are “trading more steadily” —or so it seems—although volatility has barely subsided (the VIX remains near 30 points). By the way, there are some positive developments this week, such as the recovery of European banks, which somewhat alleviates fears that, in addition to the energy crisis we’re currently facing, we might potentially have faced some kind of “financial crisis” due to how economic sanctions against Russia could have caused certain “disruptions in financial markets.” Additionally, the drop in commodity prices amid growing optimism that a ceasefire agreement might be possible in Ukraine is also providing some sense of relief.

The question that follows, then, is: Have we already seen the worst in terms of market adjustments?

At the beginning of the year, in light of rising inflationary pressures and, consequently, higher interest rates, we suggested that the markets might face some sort of “reversion to the mean” in terms of valuations and a “Q4 2018-style” correction, which was attributed to a “policy error” on the part of the Fed. (https://www.fynsa.cl/newsletter/una-clasica-historia-de-reversion-a-la-media/)

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

Markets have their own “rules,” even if they lack a strong fundamental basis. For example, the definition of a bear market is limited to a 20% decline from highs to lows; anything below that is only interpreted in the context of a “crisis” and recession. Therefore, it seems no coincidence that the decline in the Nasdaq and other markets, such as Europe, has been limited to around 20%. However, at a more aggregate level, the S&P 500 and the MSCI World Index show a more modest decline of around 10%, which qualifies as a “classic correction.”

This raises several questions… Could this be the end of the market correction? How will we know when it’s over? And are we at risk of a bear market? Earlier this week, Gavekal published a study that offers some clues and which I think is spot-on.

Looking back at the bear markets of recent decades—the Asian financial crisis, the dot-com crash, the mortgage crisis, the euro crisis, the 2015 Chinese stock market crash, the 2018 Christmas sell-off, and the 2020 COVID panic—it’s fair 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. Thisis what happened in 1998 after the collapse of LTCM, in 2001 after September 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,” the stock markets tend to rebound.
2. Oil prices are plummeting. Risingoil 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 required to finance the world’s energy reserves. Similarly, a drop in energy prices frees up excess capital, which can be redirected to other, perhaps more speculative, uses. A sharp collapse in energy prices—such as in 1997–98 during the Asian crisis, or in 2020 amid the COVID-19 panic—can help global stock markets find their equilibrium.
3. Yields on long-term U.S. Treasury bonds are plummeting. Aplunge in long-term yields is a sure sign that the markets are in the throes of panic. The resulting low yields (i) encourage central banks to ease monetary policy and (ii) make all other assets more attractive in relative terms. Most investors seek a minimum return when putting their capital at risk. If they can earn 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. Perhapsthe 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. Essentially, the risk premium on stocks is so high that anything short of absolute Armageddon almost guarantees attractive long-term compound returns.

So, returning to the original questions: Are we in a bear market? And could it be coming to an end? At first glance, 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 U.S. and 5.8% in the eurozone, it seems unlikely that Western central banks will flood the system with new liquidity in the short term. If they do, they will run the risk of being accused of bailing out wealthy investors at the expense of ordinary families’ real incomes. The only major central bank that is easing policy today—and is likely to continue doing so for the foreseeable future—is the People’s Bank of China.
• The war in Ukraine and the resulting sanctions against Russia mean that energy markets will remain tight for the foreseeable future— or at least until high oil prices disrupt the global economic cycle, which would hardly be good news for asset prices.
• Despite geopolitical risks and the sharp decline in stock markets, long-term U.S. bond yields have barely fallen —and have even risen again—as inflationary pressures become more evident.
• Valuations in most equity markets are still far from “sufficiently attractive” levels. Global equities would need to decline by an additional 10% to converge with long-term averages. (See attached Chart 1)

In summary, markets appear to remain vulnerable to further adjustments. If geopolitical tensions ease, concerns will once again focus more strongly on inflationary risks and policy tightening. Global financial conditions have become more restrictive. (See Figure 2)

In any case, our baseline scenario does not factor in the risk of a recession—at least not in the U.S.—and with China implementing supportive policies, we believe that, with the exception of Europe, the risks of a recession remain limited at this time . Therefore, we do not believe the conditions for a “bear market” are present. Thus , any further correction should be viewed as a buying opportunity for global stocks.

Humberto Mora

Strategy and Investments