The return of inflation has taken a lot of people by surprise, although it should not have done. Worryingly, even central banks have acted quite surprised by the abrupt rise in prices, when they should have expected it.
Russia’s war on Ukraine is throwing gas on the already raging fire sparked by too much liquidity in the system and by supply chain strains.
Investors have taken money out of almost all asset classes in the first half of the year, but there are timid signs that the selloff may be reaching a peak.
Investment grade debt funds saw a modest inflow last week for the first time in six weeks, according to data from Bank of America, with mid-and long-term bonds being favoured by investors.
Outflows continued to plague short-term investment grade bond funds and high yield debt funds (although the pace of them halved compared to the previous week).
Stocks saw money running out for the 22nd week in a row, but the speed of the capital outflows halved in their case too.
Does this mean the market capitulation is over? There are reasons to believe it could be. First, investors seem to believe that the worst consequences of Russia’s war on Ukraine are priced in (this may be wrong, of course).
An energy crisis this coming winter, coupled with a food crisis, could create problems for some countries, but also opportunities for others.
US shale gas and liquefied natural gas producers would probably continue to do well due to the shortage of energy, while the disruption in food supply would benefit agricultural goods producers in Latin America, Asia and Africa.
Second, it is becoming clear that a recession will be hard to avoid, even in the US. The spike in energy and food prices is bound to reduce demand and cut consumption of even the most basic products.
Markets are forward-looking, so it is probably partly because of this realisation that investors are beginning to buy longer-term bonds again: they might believe that central banks will have to cut interest rates again in the future, to stimulate economic growth.
The third reason why capitulation may be over is something quite complicated, which will unfold over the longer term.
Russia’s war on Ukraine is in fact a war on the West. Vladimir Putin has stated that he considers the dismantling of the Soviet Union in 1991 a tragedy, so it is clear that his ambitions are to at least rebuild the USSR.
China has pretty much declared itself on Russia’s side, while India is not far off either, with the leaders of these big and important emerging markets openly friendly to Putin.
This will mean that countries in the European Union, as well as the United States, will need to bring back a lot of the production they had outsourced to China and India, as these two formerly reliable trading partners can no longer be trusted to deliver the goods.
While on the short term this means inflation would rise, over the long term it will be good for economic growth, because employment levels will rise and hopefully prosperity will follow.
So, although there is still pain ahead for the European and US economies in the short term, over the longer term these may end up benefiting from the current state of global affairs. Financial markets are forward-looking, so maybe investors are trying to price this in