December 1, 2021 – Fears around the newest COVID-19 variant, Omicron, have jolted investors out of a holiday lull, sending risk assets lower, bond prices higher, and whipsawing expectations for future Fed policy. We see the Omicron variant as widening the range of possible economic and market outcomes over the next three to six months. However, at this time there are more questions than answers pertaining to the threat posed by this variant, and we are maintaining our current positioning: overweight to equities, underweight to fixed income, with excess cash that we are looking to deploy should volatility present opportunities.
Sell first, ask questions later
The rapid ascension of Omicron as a “variant of concern” took place during a typically quiet, low-volume holiday week. When markets opened on Black Friday in a shortened session, the Dow Jones Industrial Average fell approximately 2.5% for the worst single-day return of the year. Small-cap equities and international stocks fared even worse, the latter already in the midst of another wave of the Delta variant resulting in localized restrictions and lockdowns. The CBOE Volatility Index (VIX) spiked to its highest level since February of this year. The 10-year Treasury yield fell below 1.5% as investors fled to the safety of bonds. Market participants knew next to nothing about the new variant yet appeared willing to dump risk assets ahead of obtaining answers. In our view, the sharp market movements on Friday resulted from a combination of fear, low liquidity, and momentum-based algorithmic trading strategies.
Equity markets have traded with higher volatility through mid-day Wednesday, recovering on Monday, selling off again on Tuesday on the back of hawkish comments from Fed Chair Powell, and then recovering Wednesday again. By mid-day Wednesday, the S&P 500 index was less than 2% off its all-time high. While this decline is by itself not alarming or out of the ordinary for typical equity market volatility, it is atypical for this time of year, when favorable seasonality tends to result in solid performance for stocks.
It is important to emphasize that the list of what we do not know about this current variant is longer than the list of what we do know, including how fast it spreads, its lethality, and the efficacy of current vaccines and anti-viral treatments. The magnitude of the mutations to the spike protein not seen in previous variants and the possibility that it could evade current vaccines is the most alarming aspect. At the same time, it remains a possibility that this new strain, while evincing a higher transmissibility, also carries a lower potency with similar vaccine susceptibilities as former Covid-19 strains. In fact, very early clinical evidence suggests Omicron to be a more transmissible but less potent strain. By contrast, a more negative scenario would involve rising hospitalizations as Omicron spreads to areas with older populations and the need for vaccine makers to retool the current vaccines to specifically address this variant (a period of time estimated to be at least 100 days before accounting for a possible re-run of FDA approvals). We should know more in the next couple of weeks, but until then, the market is likely to remain volatile and sensitive to any headlines on rising case counts, hospitalizations, or policy responses. Absent evidence of meaningfully higher Omicron virulence and/or vaccine resistance, volatility should be used opportunistically to deploy excess cash, including our tactical overweight in client portfolios.
It is too early to assess the economic impact of the Omicron variant, since so little is known at this time. Instead, we lay out our assessment of the economic trajectory before the appearance of the new variant.
Fortunately, the U.S. and global economies were in fairly good shape before the appearance of the new variant. After a disappointing third quarter, total real spending rose at an annualized rate of 8.7% in October, with a healthy split between goods (12.6%) and services (6.6%). U.S. consumers are still sitting on trillions of dollars of excess savings, and we believe job growth will continue at an average of 500,000 jobs per month over the next year. Firms appear optimistic, too, with orders for new capital goods (excluding the volatile transportation sector) posting new all-time highs each month for nearly a year. Domestic and international firms will be restocking their inventories, which are at all-time lows relative to sales.
Outside of the U.S., Europe is set to receive a boost of €750bn ($850bn) from the EU Recovery Fund in 2022, and we expect the group of eurozone countries to post stronger economic growth (above 4%) than the U.S. (3.5%) in 2022. Japan’s new prime minister too just announced a record ¥56tn ($490bn) stimulus package, most of which will come in the form of spending. We believe emerging markets will benefit from overall global growth, strong demand for manufactured goods, and increases in overall trade.
Of course, Omicron could change the equation. In a worst-case scenario, the new variant could magnify many of the inflationary pressures that have built up in recent months. Spending could rotate from the recovering services sector back into goods (Figure 1), adding to supply chain backlogs. The labor market recovery could be delayed, particularly the expected return of millions to the workforce.
With or without the new variant, inflationary risks could force the Fed into a difficult spot. Since the onset of the pandemic, increasing COVID risks have elicited a dovish response from the Fed. But with the current inflationary backdrop, the Fed is contemplating accelerating the tapering of quantitative easing and the potential start of rate hikes, as evidenced by Chair Powell’s Congressional testimony on Tuesday. A faster tightening of monetary policy is adding to investor jitters and weighing on some of the highly valued “stay-at-home” stocks that have benefited during the pandemic. (Higher interest rates can create more of a headwind to stocks trading at elevated valuations and with much of their growth expected far in the future—sometimes referred to as long-duration assets.)