The markets are "trading more steadily," or so it seems, although volatility has not subsided much (the VIX remains close to 30 points). Incidentally, 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 are currently facing, we could 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 fall in commodity prices amid growing optimism that a ceasefire agreement could be possible in Ukraine also brings a 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, we suggested that, given the increased inflationary pressures and therefore interest rates, the markets could face some kind of "reversion to the mean" in terms of valuations and a "Q4 2018-style" adjustment, 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 discussed how focusing primarily on geopolitical risks could divert attention from what is really important in the markets today, namely rampant inflation and the dilemma facing central banks in terms of balancing the downside risks to growth and the upside risks to inflation, which 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 "codes," even if they have no fundamental basis. For example, the definition of a bear market is limited to a market decline from peak to trough of 20%; anything below that is only understood 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 20%. However, at a more aggregate level, the S&P 500 and the MSCI World show a more limited 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? During the week, Gavekal published a study that provides some clues and which I think is spot on.

Looking back at the bear markets of recent decades—the Asian crisis, the dot-com crash, the mortgage crisis, the euro crisis, the 2015 Chinese stock market crash, the 2018 Christmas massacre, the 2020 Covid panic—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. 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," stock markets are likely to rebound.
2. Oil prices collapse. 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 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, such as in 1997-98 during the Asian crisis, or in 2020 with the Covid panic, can help global stock markets find their equilibrium.
3. Long-term US Treasury bond yields collapse. Acollapse 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 ease 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 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. 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 ending? At first glance, none of the four conditions for a market bottom appear to be 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 in the short term. If they do, they 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 today, and 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 break the global economic cycle, which would hardly be great news for asset prices.
• Despite geopolitical risks and the rapid decline in stock markets, long-term U.S. bond yields have barely fallen back, and have even risen again, as inflationary pressures become more apparent.
• Valuations in most equity markets are still far from "sufficiently attractive" levels. Global equities would need to adjust by an additional 10% to converge to long-term averages. (see accompanying chart 1)

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

In any case, our baseline scenario does not consider recession risks, at least not in the US, and with China implementing supportive policies, we believe that, except for Europe, recession risks are still limited today. Therefore, we believe that the conditions for a "bear market" are not in place. Any further adjustments should therefore be interpreted as an opportunity to buy global equities .

Humberto Mora

Strategy and Investments