Anna Moneymaker/Getty Images Optimism that the Federal Reserve might back off of aggressive interest rate hikes is giving way to something else within financial markets: A feeling that things won’t likely get better for investors from here. Financial markets have vacillated between two narratives: One in which the prospects of weaker growth and financial instability force policy makers to ease up on rate hikes, the other being that central bankers proceed anyway despite any damage inflicted on markets and the economy. For now, the latter view is winning after Fed officials came out in support of continuing to lift borrowing costs. While markets have not yet morphed into an actual state of alarm, an increasingly dark sentiment is starting to brew behind the scenes.Nikko Asset Management’s John Vail said a “short but scary” global recession is likely to be ahead. Ben Emons of Medley Global Advisors said Wednesday’s decision by major oil producers to cut production, starting next month, has the potential to turn into a prolonged stretch of higher inflation and big market swings. And volatility expert Harley Bassman said stocks could drop as much as 20% from where they are now — a magnitude similar to the single-day decline that took place during 1987’s “Black Monday” scare.“We risk now seeing an orderly decline in markets become disorderly, and it’s almost impossible to tell where the sense of dislocation comes from in advance,” said Phil Toews, chief executive and lead portfolio manager at Toews Corp., which manages $2.2 billion in assets. He referred to the meltdown in the U.K. bond market that took place during the last two weeks of September as a “heart-stopping” moment, which “created a perception of vulnerability that is undeniable for the rest of the world.” “We would agree that we have a potential for a big stock market decline ahead of us,” Toews said via phone. “If you look at the 12 stages of grief, the first stage is the state of denial and that’s where we are. Inflation in the U.S., in the past, has not been a brief phenomenon — it’s lasted for years whenever it has happened — so the idea of it coming down quickly would be an anomaly.”The notion of a Fed pivot away from aggressive rate hikes was buttressed by last month’s panic in U.K. markets, when a tax-cutting fiscal policy plan unveiled by the new government on Sept. 23 led to a worrisome selloff in government bonds and a plunging pound. Fears that pension funds might collapse led to an emergency intervention by the Bank of England. This week brought a pair of unrelated developments for investors to also weigh. The first was concerns about the financial health of Swiss banking giant Credit Suisse CH:CSGN, which drew comparisons to the 2008 collapse of Lehman Brothers and fed into fears of a broader crisis at a time when cracks have been forming in credit markets. Then came Wednesday’s decision by the Organization of the Petroleum Exporting Countries and its allies to cut production by 2 million barrels a day, beginning in November — fanning the flames of inflationary worries. Before Wednesday’s OPEC agreement, investors seemed willing to brush aside the Credit Suisse and U.K. bond-market developments — sending equities to their strongest start to a calendar quarter since 1938, while traders clung to the idea that any signs of market trouble might translate into a shift away from aggressive hikes by the Fed.Read: Why investors are dismissing — even welcoming — signs of cracks in the global financial systemOn Wednesday and Thursday, though, Fed policy makers such as San Francisco Fed President Mary Daly, her colleague Raphael Bostic from Atlanta, and Neel Kashkari of Minneapolis threw cold water on the idea of a pivot. Stocks DJIASPXCOMP reacted accordingly — finishing modestly lower on Wednesday and down again on Thursday after Kashkari said the central bank is nowhere near being able to pause its aggressive interest-rate hikes.In an email on Thursday, Bassman, a California-based managing partner at Simplify Asset Management and creator of what’s now known as the ICE BofA MOVE Index, Wall Street’s most widely followed measure of fixed-income volatility, said a 20% drop in stock valuations from where they are now “could happen, but it will NOT happen in a single day,” as it did with 1987’s Black Monday moment. In contrast to Toews’s views, Bassman said “the decline will happen in a somewhat orderly manner” — which is why the Cboe Volatility Index VIX, a measure of expected volatility in the U.S. stock market, “has a hard time staying above 30, while the MOVE is hugging 150, which is a ‘panic level.’ ” The potential for a 20% stock-market decline from current levels is “dependent upon corporate earnings declining, which would be a consequence of significant rate increases, specifically in the housing market,” Bassman wrote. Adding to anxiety in financial markets is the idea that Treasury yields, already around 4% or heading there, might rise even further to 5% as central banks try to get on top of inflation.Investors have at least two more key data releases still ahead: One is Friday’s U.S. nonfarm payroll report for September, which economists surveyed by The Wall Street Journal forecast will show a 275,000 gain — down from 315,000 in August, but still strong enough to keep Fed rate hikes on track. Next Thursday is when September’s consumer-price index lands, and traders are expecting another 8%-plus annual headline inflation rate that would mark the seventh consecutive reading at such levels.Wednesday’s oil-production-cutting agreement by OPEC+ has the potential to keep energy prices “much more elevated” into next year, undermining the possibility that inflation could ease in 2023, Medley Global Advisors’ Emons said via phone. The group’s 2014 decision not to cut production, for example, resulted in what Emons calls “several years of very low inflation.”It’s not just the U.S. where investor sentiment seems to be darkening. At Japan’s Nikko Asset Management, the firm’s global investment committee “has narrowly decided on a scenario of a short but scary global recession,” with “major downside risk for markets and economies in the 4Q [fourth quarter],” said Vail, Tokyo-based chief global strategist. That should be followed by “major upside as commodity prices fall further and central banks relent.”“We have said for years that no one should doubt the ability of U.S. corporations, in particular, to boost profits, but the quarters ahead should be especially challenging,” Vail wrote in an email. “Investor sentiment, meanwhile, will likely turn very negative.”
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