10th December 2021
It’s just over two weeks since concern about the emergence of the Omicron variant triggered a Black Friday for global markets.
What do now know and what are the investment implications?
Although it is still early to draw definitive conclusions, the consensus that is emerging on Omicron at this stage is:
(1) it is more transmissible than Delta,
(2) the disease/infection is less severe and
(3) existing vaccines offer less protection but boosters offer strong protection.
Taking that as the base line would point to higher cases in the months ahead, and restrictions staying in place in many countries until booster vaccines are more widely rolled out and we get closer to the spring when cases should naturally peak.
There are risks on both sides of the baseline:
if Omicron is more transmissible but infection is associated with very mild symptoms that would be an upside risks for risk assets
whereas high transmissibility, less protection from vaccines and more severe disease would be a downside risk for risk assets.
Under the baseline scenario, from an economic perspective there would be an adverse impact on both the demand side (reduced spending on services as people stay at home a bit more) and the supply side (less participation in the labour market and possible factory shutdowns in some emerging economies) in the short term but markets are forward looking and would likely look through this to a more positive scenario in the spring (when booster vaccines have been more widely distributed).
From a monetary policy perspective assuming Omicron follows the baseline scenario, central banks are likely to continue to remove stimulus as concerns about supply side challenges keeping inflation elevated will remain (although there is a case to be made that it may prompt the Bank of England to postpone raising rates this month).
Although the November US nonfarm payroll numbers, released last week, were mixed with the establishment survey and household surveys providing different pictures, overall the picture of a slow economy and an improving labour market is still in place.
A more significant factor for markets moving into 2022 is likely to be the outlook for Fed policy.
Fed Chairman Powell has not for the first time pivoted on monetary policy in recent weeks by:
(1) signalling a faster pace of tapering and
(2) retiring use of the word transitory to describe inflation
I think the Federal Reserve will press ahead with a faster pace of tapering.
This century Fed tightening cycles have been guided by a gradualist approach by former fed Chair Bernanke. The idea being that changes in monetary policy should be small and well-telegraphed because the future is inherently unpredictable and to allow markets tie to adjust.
Moving to a faster pace of tapering therefore is a significant shift in Fed behaviour my opinion.
3 key factors are driving the Powell pivot:
inflation has been higher than expected this year,
the strength in demand and importantly
political pressure now that higher inflation has become a political challenge for the Biden administration.
The focus is now shifting to the timing of the first rate increase and the extent of the tightening cycle. Interestingly only a month ago when asked Fed Vice Chair Clarida wasn’t even thinking about thinking about the terminal rate for Fed funds in the cycle but that will increasingly be a question for markets as we move into 2022.
The consensus in the market appears to be that that each peak in the Fed tightening cycle has been lower and because the economy is more indebted the peak Fed funds in this cycle is likely to be lower than in 2018.
Market implications
Historically, the early part of the policy tightening cycle has been positive for equities and higher ates has tended to be negative for equities only towards the end of the cycle when monetary policy moves from accommodative to tight.
That said there have been record flows into equities this year, the pace of liquidity injection will slow and higher wage demands could be a headwind for margins so we could be moving to a choppier phase for risk assets.
On the rates side with the Fed moving to re-establish inflation fighting credentials the bear flattening looks likely to continue.
The Fed will still have a huge balance sheet post tapering and will continue to invest maturing securities which will provide some support for the long end, a further support for the flattening trend.
The USD appears to be the obvious beneficiary of the current backdrop with the ECB and the BOJ likely to significantly lag the Fed tightening cycle.
Although the ECB may soon move to curtail asset purchases they are likely to lag the Fed in terms of rate increases at least in 2022. Recent comments from the ECB suggest they are tolerant of the higher inflation not just because of the belief it is transitory but also because of the decade long undershoot of inflation in the eurozone.
With a strong US economy and elevated inflation there are unlikely to be objections from the current US administration about USD strength.