Believe it or not, the market has three reasons for optimism

By Mohamed A. El-Erian

To say the first half of the year was painful for investors would be an understatement. Those holding stocks, corporate bonds, emerging market securities, cryptocurrencies and other assets suffered heavy losses, and for most of the past six months, received no protection from government bonds whose traditional risk-reducing properties gave way in great losses.

Really, apart from oil and some other commodities, it was a dismal picture everywhere in the markets. It is only a matter of time before private equity valuations follow suit.

This is an environment in which it is difficult to speak with optimism, especially when so many analysts are warning that there could be additional losses in both public and private markets. However, three are already apparent.

First, genuine and sustainable value is being restored after a period in which asset prices have been artificially inflated, and distorted by massive and predictable injections of liquidity from central banks. Already some important individual stocks are oversold, having been technically tainted by a generalized sell-off as liquidity recedes.

Second, after stocks fell, and in the process experiencing historic losses, government bonds are resuming their role as risk mitigators in diversified investment portfolios. This is better news for investors who, for most of the first half of this year, felt there was nowhere to hide.

One reason for the return of the traditional correlation between the price of government bonds (the risk-free asset) and stocks (the risky asset) is that the three main risk factors have evolved in sequence—the third reason for optimism. If they had worked at the same time, the damage to markets and the economy would have been significantly worse,

The market selloff started with increased interest rate risk, due to inflation and the US central bank’s subdued reaction function. This hit bonds and stocks hard. In recent weeks, higher credit risk emerged as investors worried that the Fed’s delayed response to keep pace with inflationary realities would push the economy into recession. The longer these two risks persist, the greater the threat of unleashing a third, more damaging risk factor: stress on market functioning.

For long investors, it will prove beneficial over time for markets to exit an artificial regime maintained for too long by the Fed that has resulted in relative price distortions, misallocation of resources, and investors’ lack of visibility into corporate and state fundamentals. The promise now is that of a more sustainable destination. Unfortunately, it comes with an unpleasantly uncomfortable choppy ride.