The domino effect

Surging inflation is triggering chain reactions. Only one thing is sure: this will be a hot summer

In March 2022, we headlined one of our articles “The only thing certain is uncertainty”. Three months later, this headline seems timelier than ever. In fact, in reaction to galloping inflation and growing political pressures, central banks in developed economies have begun to raise rates. While they have so far done so moderately, this nonetheless mark a return to conventional monetary policies with the end of quantitative easing, except in China, and, hence, less liquidity on the market.

This might have hit market valuations less hard if it wasn’t happening amidst a pronounced slowdown in economic growth. As a result, the spectre of stagflation is very much haunting the global economy, as is readily apparent on the markets.

Investor nervousness is showing up in high volatility

Let’s take the example of VIX, the index that reflects implied volatility in US equities. Despite the robust market rally over the past two years, VIX has never pulled back to its pre-Covid levels. This points to heightened investor stress. In terms of performance, with the exception of two steep monthly drops in April and June, the other months have been almost flat, but only after a steep run-up in volatility during the month. May is a good illustration of this, as the S&P 500 ended the month up by 1 basis point after being down by as much as 11.5% during the month. A real rollercoaster ride!

Tech giants have clay feet

It was the investor darling for a decade, but the US tech index, the Nasdaq, is now down by more than 30% on the year to date. Looking more closely, we see that some tech segments, such as those represented in ARK Innovation, a now-infamous ETF, are closely replicating the bursting of the Internet bubble of the early 2000s.

Now spreading to all asset classes

And it’s not just the equity markets that are falling. Since May, corporate bonds have also been under attack, with spreads widening sharply and in all market segments. Not to mention cryptos, which are suffering massive deleveraging. In a way, they are experiencing not their Warholian 15 minutes of fame, but, rather, their “Lehman” moment, with some cryptocurrencies crashing, some market participants defaulting, and some initial broker bankruptcies.

Earnings releases will drive the trend

So, what to make of the markets in the first half of 2022? And, more to the point, what will they do in the coming months? We will find out a little more during quarterly earnings releases, which begin next week and will set the tone for the rest of the year. Some companies will probably announce lower figures and narrower margins, but the real question will be: by how much and in which sectors?

Selectiveness is the watchword

Counterintuitively, the correlation between sectors and individual stocks has recently risen significantly compared to six to nine months ago. As a result, equity investors thinking about shifting back to a risk-on stance by buying stocks that have become attractively priced by historical standards should be even more selective than usual. That being said, it is clear that most long/short managers are still very defensive at this point, with historically low market exposure. The only glints of hope are from China, where equity markets appear to have bottomed out recently with the backing of the monetary authorities.

Don’t go outside this summer without your umbrella

Market euphoria has not traditionally been a hallmark of the summer period. August, in particular, is usually marked by a certain listlessness. But even if the markets are quiet at times, there will mostly likely be some jerkiness. With this in mind, cautiousness is the byword. Holding on to some cash therefore makes sense, as does active management with a focus on traders, who are able to generate quick returns and whose use of options gives them positive convexity.

To sum up, the current state of the financial markets reminds us that investment is still the business of professionals and that when your taxi driver starts talking up cryptocurrencies, it is not necessarily a buying signal. Keep that in mind!