With the risk of more blow ups and cheaper equity prices on the horizon, investors should ensure they can act on opportunities.

How to be ready when the sharemarket bargains arrive (afr.com)

Tightening cycles often end spectacularly in corporate failures and risks of financial contagion. After 13 years of ultra-loose monetary and fiscal policy, and an insatiable chase for yield creating a giant carry trade, the back end of this cycle was always going to create casualties as the cost of capital rose sharply and the liquidity in markets dwindled.

Global equities have pulled back 10-15 per cent since their highs 15 months ago, and long-term investors are rightly asking if this market turmoil is an opportunity to put money back to work in stocks.

But all the ingredients to call a market bottom are probably yet to arrive. Equity valuations and earnings remain too high given the expectations of elevated bond yields and a slowing economy. Market lows are usually accompanied by panic selling and despair – and we haven’t quite hit that point yet.

This tightening cycle is approaching an interesting inflection point. The rapid rise in interest rates combined with quantitative tightening has started to break things. As the fight against sticky inflation has progressed, we have begun to see more pockets of financial distress – extraordinary bond volatility, illiquid trading in the large UK gilt market, crypto bankruptcies and, more recently, runs on banks and corporate failures.

Many have been warning for some time that investors needed to ready themselves for the next investment cycle and beware the unwinding of leverage as interest rates rise.

Serious downturns are triggered by a lack of liquidity and a breakdown in trust in the capital markets and its institutions. The global financial crisis (GFC) originated with poor credit standards, model changes by rating agencies, a capital hit to financial institutions and someone yelling fire in a crowded room.

Is this cycle any different and is now time to put some money back to work?

Picking the low points in equity markets is never easy. The enhanced regulation since the GFC, particularly around credit standards and the capital requirements for systemically important institutions, is likely to lead to a different cycle this time around.

Central banks have been walking a delicate tightrope for months –progressively applying the brake (with higher interest rates and balance sheet reduction) while occasionally feathering the accelerator by injecting liquidity into the banking system. The recent collapse of Silicon Valley Bank and other banking issues has seen the Federal Reserve introduce a new facility to provide liquidity for the par value of Treasuries on bank balance sheets. This is a short-term fix where banks can effectively borrow more than the market value of their collateral. The longer-term implications of unrealised losses on balance sheets remain to be seen.

The collapse of Credit Suisse and the hasty takeover engineered by the Swiss regulators is another intervention aimed to shore up confidence and maintain financial liquidity. Some commentators warn that bank failures show the zombie apocalypse has begun. They argue that the dominoes have started to fall and lower asset valuations and further falls in equity markets are inevitable.

There is little doubt that the next few months will be challenging for central banks. They will attempt to talk tough on inflation, holding rates at contractionary levels while simultaneously trying to keep liquidity flowing through the system and supporting the solvency of the banking system.

Central banks have increased the backstop against contagion. Only time will tell if this will be enough to avoid more bank runs and solvency questions. But even if this is sufficient, market participants will get little relief as they refocus on the fundamental economic factors. Inflation remains stubbornly high and there is a significant opportunity for short- and long-term yields to rise over the next couple of months.

Psychology will play a pivotal role in what happens next, and markets are expected to remain captive to the news cycle. Those with a genuine long-term investment strategy are likely to start averaging in if they have spare funds. On the flip side, many short-term investors are probably suffering from sticker shock and are hoping to sell equities at better levels – kicking themselves that they didn’t do so earlier. Those who have chased higher yields in illiquid assets are facing revaluations and an inability to redeploy capital should the markets pull back further.

Short-term fluctuations and market downturns can be nerve-wracking for investors, but staying invested or buying pullbacks has been a strategy that has worked over the long haul. And with the risk of more blow ups and cheaper equity prices on the horizon, investors should ensure they have enough liquidity when the real bargains arrive.