Believe it or not, the market has three silver linings

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To say that the first half of the year was painful for investors would be a gross understatement. They suffered big losses on their holdings of stocks, corporate bonds, emerging markets, crypto and other assets; and for most of the past six months they have not received protection from government bonds, whose traditional risk mitigation attributes have also given way to large losses.

Aside from oil and a few other commodities, it was indeed a bleak picture in the public markets. It’s only a matter of time before valuations in the private equity space catch up.

This is an environment where it’s difficult to argue for silver linings, especially when so many analysts are warning that additional losses could be on the way in both public and private markets. But three are already recognizable.

First, real and more sustainable value is being restored after a period in which asset prices were artificially inflated and distorted by huge and predictable central bank liquidity injections. A few prominent individual stocks are already in oversold territory, having technically been contaminated by a general sell-off as liquidity has declined.

Second, government bonds are resuming their role as risk mitigators in diversified investment portfolios after tracking equities lower, suffering historic losses in the process. This is better news for investors who, for most of the first half of this year, felt they had nowhere to hide.

One reason for the return of the traditional inverse correlation between the price of government bonds (the “risk-free asset”) and stocks (“risky”) is that the three main risk factors have evolved sequentially – the third silver coating. Had they acted simultaneously, the damage to markets and the economy would have been far greater.

The market sell-off began with rising “rate risk” due to inflation and the Federal Reserve’s sluggish policy response function. This hit both stocks and bonds hard. Higher “credit risk” has added to the mix in recent weeks as investors feared a late Fed struggling to catch up with inflation realities would push the economy into recession. The longer these two risks persist, the greater the risk of unleashing the third, more damaging risk factor: stress on market functioning.

Long-term investors will benefit over time as markets emerge from an artificial regime maintained by the Fed for far too long that has led to inflated valuations, relative price distortions, and misallocations of resources and investors supporting companies – and government bonds lost sight of fundamentals. The promise is now one of a more sustainable destination. Unfortunately, it comes with an uncomfortably bumpy and disconcerting ride.

More from other authors at Bloomberg Opinion:

• Cuban Crisis Parallels gives stocks a 1962 look: John Authers

• Bond market recovery is bad news for the economy: Gary Shilling

• Average investors should try to time the markets: Jared Dillian

This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.

Mohamed A. El-Erian is a columnist for the Bloomberg Opinion. A former Chief Executive Officer of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor of Allianz SE; and Chairman of Gramercy Fund Management. He is the author of The Only Game in Town.

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