Why the markets are defying the downturn of war, interest rates and inflation

Why the markets are defying the downturn of war, interest rates and inflation

Indeed, Wednesday’s frightening reports that a Russian missile attack on the Poland-Ukraine border has killed two and sparked a spate of crisis meetings in Poland that threaten to draw NATO into the conflict show geopolitical risks are not waning either .

And yet the markets tell a very different story.

Australian resilience

This&The P 500 index is up 11.4 percent from its October lows. In China, the Shanghai Composite is up 8.3 percent since October 31. Germany’s DAX Performance Index is now officially in bull market territory after posting a 20.6 percent gain since October 12.

And in Australia, the benchmark ASX 200 is up 10.6 percent since early October and down just 5.9 percent since the start of the year. Given the rate hikes we’ve seen, the turmoil in bond markets, reckoning in the tech sector, and the cryptocurrency meltdown, this would be a remarkable result.

So what’s happening right now? How can the bulls suddenly be on parade when every investor is desperately worried about what’s in store for 2023?

The contradiction is not as great as it might seem.

Yes, stock market capitulation is not nearly as great as bearish sentiment suggests – BoA data shows that for every $100 in inflows into stock markets, there were only $1 in outflows, compared to $61 in outflows in the March Pandemic and $113 in outflows in the depths of the GFC.

Oversized effect of good news

But the fund manager survey tells us that cash allocations are very high and equity allocations are declining, suggesting relatively low positioning. And that means any good news can spur a rally.

In the US, that good news came in the form of weaker-than-expected inflation data last week, which seem to have confirmed that the peak in inflation is probably behind us.

In China, mounting signs that the government is beginning to back away from its COVID-zero policy, along with (another) housing sector bailout, have lifted sentiment.

This has impacted commodity prices, giving a further boost to the resilient Australian market.

And in Germany, success in filling gas storage ahead of the northern hemisphere winter and hopes of mild weather over the next four months have helped equities broaden their recovery from severely oversold levels.

The big question, of course, is whether this momentum can be sustained and whether this bear market rally can grow into something stronger.

Inflation in the front and in the middle

There are clearly many reasons to be cautious, from the conflict in Ukraine to China’s faltering recovery and housing problems. But the big clock is inflation, which is the focus for all investors.

A spike in CPI clearly increases the potential for a turnaround by central banks, even if this is just a pause in rate hikes rather than a shift to outright rate cuts. But a pessimist might also say that there is bad news everywhere.

If you believe that inflation will remain stubbornly and stubbornly high, then central banks have a lot more work to do and the chances of a deep recession increasing, while you believe that it has peaked and will fall quickly, then economies will also likely to cave in and take lower profits, which isn’t good for stocks.

Interestingly, Bank of America Chief Strategist Michael Hartnett outlines two distinct and contrary outcomes up to 2023.

The first is a bullish “Goldilocks” scenario, where inflation falls quickly and the Federal Reserve could cut interest rates by the end of 2023. The second is what he calls a “debt deflation” scenario, where inflation remains a problem. Central banks continue to tighten, unemployment rises and a kind of explosion in credit markets ensues.

The truth in 2023 may well lie somewhere in the middle – more like the stagflation pointed out by the BoA fund manager survey.

But the potential Hartnett outlines for two very different macro outcomes – one very bullish, one very bearish – shows both the level of uncertainty and opportunity in the markets right now.

The only thing investors can really bet on in this environment is volatility.

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