OMICRON concerns and a pivot from US Fed chair Jerome Powell on inflation triggered a risk-off move in markets last week.
Equities fell — the S&P/ASX 300 lost 0.62% and the S&P 500 was off 1.17%. Longer-dated bond yields fell, as did the oil price. The VIX volatility index spiked above 30% for the first time since February.
In equities we saw a sell-off in more speculative tech stocks and a rotation towards more defensive value names.
The market has moved quickly to price in a great deal of fear over Omicron and the pace of rate hikes. There is a reasonable chance these concerns may be overdone – though there are still a lot of questions around Omicron.
However a combination of falling volatility, a strong rebound in the US economy supporting earnings, easing concerns over Quantitative Easing tapering, and receding uncertainty around Omicron could very well see markets rally through to January.
The market has two current concerns around Covid.
The first is the Delta variant’s ongoing winter wave in the northern hemisphere. The second is the potential implication of the Omicron variant.
On the latest Delta wave, there are signs leading countries in eastern and central Europe are seeing the usual peaking of cases two-to-three months in. This is positive, suggesting that targeted restrictions can be effective.
But we are also likely to see this wave roll into other parts of the continent. Cases are rising rapidly in France and southern Europe. The UK is moving back towards the top end of its range of cases. US data is distorted by Thanksgiving, but early indicators suggest a renewed wave is building there.
So far hospitalisations remain contained in the higher-vaccinated countries.
Omicron adds a new level of complexity to the outlook.
South Africa had extremely low case levels prior to Omicron’s emergence. A new wave had been expected, similar to what we’re seeing in Europe. But this low level of existing cases has allowed Omicron to become the dominant strain relatively easily.
The question is whether it can also become dominant in countries where Delta cases are already more prevalent.
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We also don’t know whether Omicron will lead to a different pattern to Covid waves — extending them or increasing the amplitude.
We continue to wait for the data on Omicron. There are three areas to watch for:
1) Ability to bypass vaccines
Data on the difference in immune antibodies could be available within a week. It seems likely existing vaccines may be less effective at preventing infection, while still conferring some immunity.
It may mean booster jabs are needed sooner than expected. Imminent data is unlikely to show the degree of protection against a severe Covid infection. Actual observations of hospitalisations will likely provide the indicator on this.
There are suggestions from a number of scientists that Omicron has a substantially higher “R0” (rate of transmissibility) than Delta. There are a number of reasons why it may be too early to definitively conclude this. These include the low level of previous cases in South Africa, the fact that Omicron is easier to detect than Delta and heightened focus on the new variant which means testing levels are far higher.
There are also suggestions it has been around for longer than a month, so we are seeing some catch up in cases reported. It may be that we need to see how Omicron spreads in a country where Delta is already prevalent to reach a conclusion.
We will be watching the proportion of Omicron patients that require hospitalisation and for how long. There has been speculation based on observations in South Africa that hospitalisations rates are lower than Delta. These reports say hospitalised patients are experiencing fewer respiratory issues and are able to leave hospital sooner. More data is needed.
Observations on Omicron severity are prompting speculation that Covid may be evolving into a more endemic-like virus. This might enable the world to build immunity without severe health implications and possibly signal the beginning of the end of the pandemic.
We believe it is far too early to buy into this thesis.
For one thing, cases reported so far have been in younger, healthier people who are more social and have lower vaccination rates. As cases spread into more vulnerable age cohorts we may see higher hospitalisations — so it is too early to make this call.
The upshot is that there are a lot of unknowns and potential outcomes.
The difference in reaction to Omicron and the pandemic’s beginning is notable.
In early 2020 governments and markets were slow to recognise the threat. Now we are seeing a sharp negative reaction with governments re-imposing travel restrictions and markets turning risk-off.
The risk scenarios can cut both ways here. There is a reasonable chance the outcome won’t be as bad as feared. Therefore we are mindful of not becoming overly cautious.
The US could be the key country to watch. Case numbers have been low, potentially making it easier for Omicron to establish itself as the dominate strain. Half of Americans are either unvaccinated or had their second shot more than six months ago, with fading immunity.
The final issue to keep in mind is the durability of the booster shot. We are watching Israel’s experience to see if immunity proves more durable after the booster.
Powell’s pivot and inflation
In his testimony to Congress, Fed Chair nominee Powell said Quantitative Easing (QE) could finish “a few months sooner” than previously indicated. He also said it was time to retire the term “transitory”. The market has moved to expecting QE to be over by end of March.
The bond yield curve flattened materially as a result. The spread between 10-year and two-year US government bonds dropped from above 100bps to about 75bps as the longer-dated yields fell.
Is it no coincidence that Powell has become more hawkish on inflation a week after his nomination for a second term as Chair.
He will need Republican votes to be confirmed by Congress — a hawkish tone on inflation helps this. Inflation is also a factor in Biden’s waning popularity and dealing with it has become a policy imperative.
We are therefore mindful of the political angle to this shift and cautious on reading too much into it.
Powell pushed rates higher in 2018 on concerns over Trump’s fiscal stimulus and almost flattened the yield curve — though he shifted quickly after equities fell sharply in response.
The great irony is that in the week “transitory” was retired, inflation expectations – reflected in the pricing of two-year forward inflation swaps — dropped materially. This partly reflects confidence that the Fed will not be complacent. Omicron concerns and some supply chain improvements are also factors.
This meant real interest rates actually rose on the week – bond yields were down, but inflation expectations were down further. This may explain the decline in tech growth stocks – particularly at the more speculative end – given the correlation with real rates.
Faster tapering means reduced additional easing, not tightening. QE has not really been a driver of the Main Street economy beyond the effect on confidence of rising share prices. As a result faster tapering should not have a material impact on the economy.
However it could see rotation away from the more speculative end of markets towards more predictable and yield sensitive stocks.
It is also important to note that faster tapering does not necessarily mean rates go up sooner. The market is pricing two-to-three hikes in CY22. This may prove too many. Powell has always been very clear that the pace of tapering and rate hikes should not be connected.
Finishing QE earlier gives the Fed optionality. If the economy is slowing and inflation easing it is unlikely to go hard on hiking rates. The lesson of 2018 is to be wary of being too hawkish.
Payroll data was disappointing. The US economy added 210,000 new jobs in November — well below consensus expectations of 550,000.
However there are a number of offsetting factors which means this does not necessarily signal a definitive change in the labour market trajectory.
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There were material, positive revisions for previous months and the latest household survey reported 1.1 million new jobs.
There were also possible early signs of workers returning to the market with the participation rate among 25-54 year olds rising 0.5%. Again, it is too soon to get too excited by this. About half the 5 million drop in workers in the last two years remains unexplained.
Headline wage growth slowed to 0.3% month on month. But underlying measures indicate it stayed at the 5-6% level, so this remains a live issue.
Concerns over tighter US monetary policy and Omicron saw de-risking in equities, exacerbated by a seasonally illiquid period in the market.
Equity market volatility, as measured by the VIX, spiked into the 99th percentile of readings. It is hard to see it moving much higher unless we see a major adverse development on Covid.
There has been a high correlation between spikes and the VIX and market corrections this year.
On this basis markets could recover into the year’s end as volatility falls. However lingering caution may see large cap and rate sensitives lead, rather than more speculative growth names.
The latter’s sell-off continues, as reflected in the relative performance of the ARK Innovation ETF as well as the BNPL, cloud, gaming and cyber security sectors versus the broader NASDAQ.
Resources are interesting — they have been tied to China growth revisions where news may be becoming slightly more positive.
In terms of sentiment we are watching credit spreads. The high yield spread over investment grade bonds has shifted up from 80bps to 130bps on recent concerns.
Oil is another indicator to watch. A combination of recent reserve releases and Omicron has seen West Texas Intermediate fall back to August’s levels — when Delta concerns peaked. If the market believes we’ll get a continuation of the global economic recovery next year we should see this bounce.
Sentiment in equity markets is softening with around 50% of stocks in the S&P 500 hitting a 20-day low. However it is not signalling capitulation.
We see scope for a recovery into January, on a combination of:
Covid remains the main caveat to this view.
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
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