Investors must remember bear market rallies always end in tears

The sudden surge in global equity markets since the middle of June must be recognised for what it is – a classic bear market rally, with weak foundations
For a sustainable turnaround in sentiment, at least four conditions need to be met and it is uncertain that this will happen

Nicholas Spiro

Published: 3:30am, 5 Aug, 2022

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Financial markets and the real economy often diverge, at times dramatically so. Investment strategists and commentators spend an inordinate amount of time trying to explain the disconnect between asset prices and economic data, which has been amplified by distortions in markets stemming from years of ultra-loose monetary policy.

While some divergences are more perplexing than others, the sudden surge in global equity markets since the middle of June ranks as one of the most baffling. In the first 5½ months of this year, the MSCI World Index, a gauge of stocks in developed economies, plunged 23 per cent. However, since June 17, it has shot up 9.7 per cent.

To be sure, the rebound has been driven by stocks in the United States, with the technology-heavy Nasdaq Composite Index up a striking 17.3 per cent. Yet, even shares in Europe, whose economy is more vulnerable because of the severity of the commodity shock caused by Russia’s invasion of Ukraine, have risen 8.7 per cent.

Moreover, it is not just stock markets that have bounced back. Government and corporate bonds, which were hammered by the dramatic increase in interest rates in most countries, have also enjoyed strong gains. Since June 14, the yield on the benchmark 10-year US Treasury bond has fallen from 3.5 per cent to 2.7 per cent, while spreads, or the risk premium, on US “junk” bonds have narrowed.

Even battered emerging market stocks, which face the double whammy of tighter US monetary policy and a sharp downturn in China, were flat last month.

That the unexpected improvement in sentiment across asset classes is a classic “bear market rally” – a short-lived rise in prices amid a longer-term decline – is beyond dispute. The question is whether there is any justification for a rally when the two major threats investors have been fretting about this year – stubbornly high inflation and the increasing likelihood of a policy-induced recession – continue to take their toll on the global economy.

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There are several possible explanations for the rebound. One is that most of the bad news about inflation and growth was already priced in. Expectations were so low that even the slightest sign that the outlook may not be as dire as feared was enough to lift sentiment.

It is also conceivable that central banks will soon be forced to begin cutting rates as economies tip into recession. In a report published on Wednesday, Marko Kolanovic, an investment strategist at JPMorgan and currently Wall Street’s most optimistic analyst, said “peak hawkishness is likely behind [us]”.

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However, neither of these explanations stand up to scrutiny. There can only be a meaningful and sustained turnaround in sentiment if several crucial conditions are met: inflation peaks and starts to come down sharply, the current downturn does not morph into a full-blown recession, leading central banks avoid a major policy mistake and there are no further geopolitical and financial shocks.

It is hard enough to imagine any one of these conditions being fulfilled satisfactorily, never mind all four simultaneously.

First, investors are reading too much into changes in tone from central banks. The US Federal Reserve’s signal last week that it may need to slow the pace of rate hikes as the country’s economy decelerates more sharply was immediately seized on by investors.

However, other hints from the Fed – there needs to be “compelling evidence” that inflation is falling to 2 per cent, while another jumbo rate hike is possible in September – were ignored. Bond markets, which are pricing in rate cuts as early as the first half of next year, are far too sanguine about the Fed’s ability to bring prices back down.

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Second, markets are betting that central banks can tame inflation without crushing the economy. Yet, the fact remains that nearly every time the Fed raised rates to or above the neutral level, it triggered a recession. The “soft landing” scenario investors are banking on looks increasingly implausible.

While the US economy has already experienced two straight quarters of declining activity – one of the conditions for a technical recession – it is Europe that is the bigger worry. A prolonged reduction in Russian gas flows threatens to cause a fully fledged energy crisis in the winter just as fears over the integrity of the euro zone resurface. If stagflation takes root, it will be in Europe.

Third, the severe escalation in tensions in the Taiwan Strait in response to US House of Representatives Speaker Nancy Pelosi’s provocative visit to Taiwan is a reminder of the increasing importance of geopolitical and financial wild cards in markets.

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To paraphrase former US defence secretary Donald Rumsfeld, if even the “known knowns” are enough to send markets into a tailspin, the “unknown knowns”, not to mention the “unknown unknowns”, could prove far more damaging to sentiment.

While it is understandable that investors are desperate for good news, the bad news will keep rolling in for some time. Bear market rallies always end in tears. This one could prove particularly painful.

Nicholas Spiro is a partner at Lauressa Advisory

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