Omicron + taper = volatility + opportunity

What did we learn?

Last week was the most volatile for global equities since February, with the S&P 500 falling 1.2% and the 10-year US Treasury yield declining 12 basis points to 1.36%, amid worries over the omicron variant of the coronavirus, central bank tightening, spare capacity in the US labor market, and Chinese technology regulation.

• Early data reinforced worries that the omicron variant has an advantage in evading the immune system. An early study in South Africa, released Friday, found that omicron is 2.4 times more likely than previous variants to reinfect someone who has already had COVID-19. This compounded market anxiety over some worrying predictions made by vaccine makers earlier in the week. Stéphane Bancel, Moderna’s CEO, told the Financial Times that “there is no world, I think, where [the effectiveness of current vaccines] is the same level” as for the delta variant.
• Federal Reserve Chair Jerome Powell indicated that the Fed would discuss winding down asset purchases faster than scheduled. Powell said that the US economy was “very strong” and inflationary pressures were high. Against this backdrop, he said the Fed would discuss ending bond buying several months earlier than previously signaled. He added that it was no longer appropriate to call the recent bout of higher inflation “transitory” and that “the factors that are causing higher inflation” have been more persistent than expected. The payroll report on Friday, which pointed to diminishing slack in the labor market, looks likely to add to momentum for an earlier withdrawal of stimulus.
• US jobs data on Friday indicated a worrying combination of weak employment growth and constrained labor supply. The US economy added just 210,000 jobs in November, less than half the consensus forecast of economists and well below the monthly average of 555,000 since the start of the year. This was combined with a fall in the unemployment rate to 4.2%, the lowest since the onset of the pandemic, causing some economists to worry that limited slack in the labor market could add to inflationary pressures.
• Regulatory steps taken by both China and the US could accelerate the homecoming of Chinese ADRs. China ordered ride-hailing firm Didi to delist its shares from the US, while the US SEC moved to better define rules for delisting ADRs that don’t comply with the requirement that company books are inspected by the Public Company Accounting Oversight Board. The S&P/BNY Mellon China ADR Index fell by around 15% over the week, and is now down 46% over the past year.

These negative developments dominated market sentiment last week. But there were also positive developments, which could come to the fore if more scientific data leads to omicron worries abating over the coming weeks.

• US economic fundamentals remain supportive of markets. While the labor market data was disappointing overall, there were encouraging elements. The participation rate increased, implying a 1.14 million increase in the number of people working. Meanwhile, the ISM Manufacturing PMI, which provides a timely snapshot of conditions in the manufacturing sector, edged up to 61.1 in November from 60.8 in October. This is a strong reading from a historical perspective.
• Market-based measures of inflation concerns have reduced. Lower commodity prices, signs of more proactive Fed policy, and some early evidence of easing supply bottlenecks have reduced market concerns about longer-term inflation. US 10-year breakevens are trading at 2.44%, down from 2.74% in mid-November. Brent crude is now around 18% below its recent peak in late October, and OPEC+ decided Thursday to raise production by 400kbpd from January. And port backups on the US West Coast are showing signs of easing.
• Healthcare companies have indicated that vaccines can be tweaked if needed. Moderna’s Chief Medical Officer Paul Burton said that even a “brand-new vaccine” to target the new variant could be developed quickly. “The remarkable thing about the mRNA vaccines…is that we can move very fast,” he said, with the potential for large quantities to be available as soon as early 2022. Meanwhile, Pfizer and BioNTech have said an updated version of the COVID-19 vaccine could be ready in 100 days if omicron turns out to be resistant to the current version. Highly effective antiviral treatments are also in the pipeline and should reduce the need for further lockdowns.

What does this mean for investors?

We expect a period of heightened volatility ahead as investors attempt to assess the risks from omicron and the Fed, based on insufficient and patchy data.

We see two bear cases: First, that omicron has sufficiently severe symptoms and transmissibility that governments turn to lockdowns to control the outbreak. The second bear case is that government restrictions delay a normalization of supply chains and drive fears of stagflation and monetary tightening.

That said, a hasty exit from risk assets could be harmful to long-term returns. Our base case is that omicron proves to be a near-term headwind but does not derail the rally. We also see a bull case in which omicron is highly transmissible but those infected show only mild symptoms. This could be indicative of the virus moving to an endemic stage, in which governments start to treat it more like other respiratory illnesses such as flu and cold.

As a result, we think investors should view potential volatility in the days ahead as an opportunity to build a more robust portfolio for the future. Diversification can help mitigate drawdowns without necessarily sacrificing future upside. We view healthcare, a defensive sector, as attractively valued, especially as uncertainty over US drug pricing policy looks set to lift. Investors should also consider increasing allocations to alternatives, such as hedge funds, many of which are well placed to outperform equities in volatile markets.

Our base case is that the market focus will shift back toward the positive outlook for economic growth and earnings. So we think investors should consider whether now is a good opportunity to add some of the winners from global growth that have been most negatively affected in recent days—including the Eurozone, Japan, energy, and financials.

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