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A more sober outlook weighs on investors

Fall has arrived and investors are looking back at a period of summer exuberance in the markets through a remarkably more sober lens.

The focus is on the curious moment in July when some fund managers abruptly convinced themselves, after a terrible start to the year, that the US Federal Reserve would decide to be merciful. Shares shot higher than hopes it could quell some of the more aggressive options for taming inflation.

It wasn’t a fleeting fad. At its worst, from mid-July to mid-August, the S&P 500 benchmark index of US-listed stocks gained about 16 percent. The MSCI World index rose at the same rate. But anyone who has timed this summer reprieve perfectly is in the minority. Now investors are pining for a grim winter after the Fed made it very clear it had no intention of backing out.

“The story of the summer rally in the financial markets that central banks could soon slow or even reverse interest rate hikes has now clearly gone out the window,” said Michael Strobaek, chief investment officer at Credit Suisse. “Markets had taken into account too much hope and too little economic reality.”

For some, the summer rally was a grim omen. GMO’s Jeremy Grantham told readers that fleeting bouts of optimism were “perfectly consistent” with a “super bubble” about to burst. “Prepare for an epic finale,” he warned.

As it should be, the merry vibes have died down – that rally has almost completely evaporated. Now the rest of the year is dominated by earnings supporting valuations and managing expectations.

“I don’t think we should tell customers we think” [markets] will skyrocket again,” said Nick Thomas, a partner at Baillie Gifford, one of the UK’s leading investors in high-growth equities. He acknowledges that market conditions are “painful,” in stark contrast to the runaway rallies that sent Baillie Gifford’s portfolios soaring last year.

The real clash of views now is whether fund managers can avoid stepping on even more rakes. Michael Wilson, equity strategist at Morgan Stanley in New York, suspects not. So far, he writes, interest rate expectations and bond market turmoil in 2022 have done the real damage to investors. In other words, if you like, you can blame the Fed for the poor performance of your investments in the first half of this year.

Now, however, that excuse is a bit flimsy. Instead, what Wilson calls the “fire” of adjusting to a new monetary environment is giving way to the “ice” of economic stress weighing on corporate profits. He thinks the S&P 500, now hovering around 4,000, is still in for a shock.

“While recognizing the poor performance in equities, [so far this year], we don’t think the bear market is over if our earnings forecasts are correct. We think the lows for this bear market are likely to come in the fourth quarter, with 3,400 the low down and 3,000 the low if a recession hits,” he says. The mere fact that stocks have already fallen hard and few have been spared the suffering is “not enough reason to be optimistic,” he says.

But this key point, about revenues and the damage they could cause, is where the arguments come in. “Everyone already knows the bad news. The sentiment is already at its lowest point,” says Thomas van Baillie Gifford. “The fact that profits are going to fall should come as no surprise to anyone.” He is quietly convinced that stocks will end the year in relatively serene style.

If he’s wrong, a source of help could be the same bond market that made the stock disappear in the first place. Of those two major asset classes, it has had an even more horrendous run.

“Global bonds have entered the first bear market in a generation,” noted Mark Haefele of UBS Wealth Management, after government bonds and high-quality corporate bonds fell more than 20 percent from their peak in 2021, according to the spicy-cited Bloomberg Global Aggregate Total. Return table of contents.

Yes, 20 percent is a random number. Nevertheless, this is the worst period in this market, the bedrock of global asset prices, since at least 1990. UBS also points out that August was the worst month for European government bonds ever, while the US market fell 12.5 percent versus from the previous one. highs – more than double the scale of any peak-to-valley pullback since the 1970s.

That means anyone hoping for bonds to fulfill their usual function and counterbalance the crumbling stock prices has had a terrible year. The good news is that such periods of simultaneous pullbacks in bonds and stocks are rare, and by 1930 they had given way to bond rallies “100 percent of the time,” UBS said. Barring a break with precedent, this means the safety net is back.

Shares have fallen, but not out. A jump earlier this week suggests the “epic finale” hypothesis is still in the minority. But stress and volatility in every major asset class is here to stay. Forget the chance of a good recovery. Anything better than a further 5 percent drop by the end of the year would likely count as a win.

katie.martin@ft.com