Omicron + taper = volatility
Originally published as a CIO alert by Mark Haefele, Chief Investment Officer
What happened?
Risk assets fell on Tuesday, with the S&P 500 down 1.9%, as concern over the impact of the new omicron variant of the coronavirus combined with renewed fears of central bank tightening.
The return to pessimism was sparked by an interview with Moderna’s CEO, Stéphane Bancel, in which he stated that omicron was likely to cause a “material drop” in the effectiveness of current vaccines.
Markets had a brief respite after BioNTech CEO Ugur Sahin said that the current generation of COVID-19 vaccines will probably still protect against severe disease, and Oxford University said there was no evidence to suggest current vaccines wouldn’t offer some protection.
However, this was soon followed by testimony from Federal Reserve Chair Jerome Powell, who surprised markets by saying it would be appropriate to discuss “wrapping up the taper” of asset purchases several months sooner than currently planned. He added that inflation should no longer be considered a “transitory” phenomenon. The yield on the 2-year US Treasury rose 8 basis points to 0.56%.
How do we interpret this?
Our base case is for the omicron outbreak to blend into the existing delta wave that the global economy has already been working through. This scenario could arise either because vaccines retain sufficient protection against the new variant, because omicron symptoms prove no worse than those of the delta variant, because omicron fails to outcompete delta, or because governments choose to manage risks with methods like vaccine booster programs and mask-wearing, rather than lockdowns. Should this materialize, we would expect market focus to gradually shift back to the positive earnings and economic growth outlook.
That said, as today’s price action has demonstrated, the market is also confronting two downside scenarios. First, that omicron turns out to be successful at evading vaccines, and virulent, leading to a renewed wave of lockdowns. Second, that—even if omicron is less harmful than feared—markets could begin to worry about central banks tightening policy more quickly than expected, particularly if efforts to limit omicron’s spread exacerbate supply chain disruptions and keep inflation elevated for longer.
We continue to assess a range of scenarios—from a best case that omicron symptoms are very mild and indicative of a virus entering an endemic stage, to a worst case that the strain leads to a renewed wave of global lockdowns. We have published greater detail on these scenarios in our latest?Risk Radar.?But as we await more data on the virus, we think it is important to retain a balanced and longer-term perspective:
What should investors do?
Over the coming weeks, we will get a clearer idea of the nature and extent of the risk posed by the omicron variant, and greater clarity about the likely path for Fed policy. Responding too quickly by reducing exposure to risk assets could undermine long-term performance, in our view. Rather, we see the latest bout of volatility as a reminder of the merits of having a Wealth Way plan and of building a well-diversified portfolio, both geographically and across asset classes.
In our base case, we expect market focus to gradually shift away from omicron and toward positive growth and earnings trajectory, allowing equities to resume their upward course, and for some of the cyclical markets particularly negatively affected by recent developments, including Japan, the Eurozone, energy, and financials, to outperform.
We also recommend the following strategies:
Seek opportunities in healthcare.?In periods of market volatility and drawdowns, defensive sectors can help mitigate portfolio drawdowns. We view the?healthcare sector?as offering both defensive and growth opportunities, and we are upbeat about the tactical and strategic outlook for the sector. The industry also looks attractively valued, especially after a recent period of underperformance. It trades at a 2% premium on a 12-month forward price-to-earnings basis to the MSCI World index, below its long-term average of 10%. A catch-up is overdue, in our view. We believe this has become more likely as uncertainty surrounding US drug pricing is resolved, which looks imminent after the passage of legislation on the issue by the House of Representatives.
Seek unconventional yield.?Despite concerns over an acceleration in the pace of central bank tightening, yields on government bonds are still well below pre-omicron levels—and 10-year US government bond yields even fell further following Powell’s comment. With yields low and spreads tight, we see few opportunities in traditional bond markets. Rather, we favor unconventional sources of yield, such as private credit or dividend-paying stocks. For more on unconventional sources of yield,?click here.
Diversify with alternatives.?Alternatives?can have several potential benefits for investors in volatile markets. Due to their illiquidity, such investments—whether in private equity or hedge funds—offer some protection against the behavioral tendency to sell into falling markets. Added to this, certain hedge fund strategies are well placed to outperform equities in falling markets. The asset class also helps diversify portfolios against the risk that equities and bonds begin to move in tandem on hopes and fears about monetary policy.
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