A market turned upside down




These are tough times for investors. Unwritten rules underpinning the financial markets’ behaviour do not seem to apply any more. In the old days, a hawkish Federal Reserve would be likely to trigger a sell-off of stocks. Especially when inflation remains close to four-decade highs and a recession is lurking on the horizon. In the past, such scenarios would have entailed a significant loss for indices such as the S&P 500 or the NASDAQ.

Not this time. As we enter the last week of August, the S&P 500 is up by about 14 percent compared to where it was in mid-June, while the NASDAQ gained nearly 18 percent. In the case of the latter, the recovery is even more surprising. The technology-heavy index has returned to a bull market, having at some point gained more than 20 percent in relation to the June lows.

But why are stock markets going up half-way through a monetary tightening cycle? Are investors feeling lucky? The answer to this last question may well be yes.

During troubled times, safe havens are expected to perform well. Assets such as gold and the Japanese Yen tend to benefit from the drop in risk appetite that usually occurs when central banks hike interest rates, and stop issuing new money and buying debt. In the old days, investors used to anticipate the negative impact such measures would have on economic growth. They would sell stocks, using the released funds to buy precious metals or very safe currencies, such as those from Japan or Switzerland.

However, this time around, investors are keeping faith in risk-related investments. This may be because, over the last decade, prices have moved only in one direction - up. The one-way traffic registered since 2009 has perhaps triggered an optimistic bias in the mindset of traders.

Another potential reason for the unusual pattern is the poor performance of traditional refuge assets. Gold lost more than 2 percent since June and, even before then, its gains were not what one would expect considering the deterioration of the economic backdrop, the war in Ukraine and weakness in stocks. The yen was also expected to perform better than it has done so far this year. The Japanese economy is incredibly resistant to inflationary pressures, a peculiarity that greatly enhances the appeal of its currency at times when prices are rising elsewhere.

A strong dollar is the reason why the two safe havens are performing below expectations. Both are priced in American currency, meaning their face value drops as the greenback strengthens. Against such a backdrop, perhaps holding cash (in dollars) could be an option. However, with inflation rising, the currency will lose real purchasing power, reducing its attractiveness for investors looking to sit-out the crisis.

So perhaps the reason why stock prices are rising, when in theory they should not, is that investors are out of options. When everything else fails to yield a return, continuing to back stocks, despite the risks, becomes a viable choice. Is it a safe strategy? No, it is not. But what else can investors do, other than cross fingers and hope for the best?


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