Central bank response to inflation remains the focus
The new Omicron variant rattled markets in the second half of November, and while there is uncertainty about its impact, our greater concern is the impending withdrawal of liquidity by the US Federal Reserve, which is looking ‘nailed on’ unless there is a market shock.
November started off on a positive note. After recovering the declines in September, global equities marched on to new all-time highs through October and November. In America, people looked forward to Thanksgiving get-togethers and were excited to have the worries of Covid-19 behind them as they met with family and friends from across the country – in many cases for the first time since 2019. Unfortunately, they were in for a rude awakening. A new Covid variant of “serious concern” was revealed in South Africa, which is believed to be even more transmissible than the Delta variant. The news of Omicron was enough to see selling into an illiquid “holiday” market which ultimately saw the S&P 500 fall over 2% and the S&P volatility index (VIX) spike to 30. Credit spreads widened, with US high yield credit valuations falling 2% and cyclical currencies like the AUD falling over 5% against the USD.
Markets caught napping
While it is too early to know the full impact of the new Covid strain, it helps highlight that markets were complacent: ignoring inflation fears, the potential for monetary tightening, and (as it turned out) the potential for a new Covid wave to upend the global economic recovery. Most indices remain fairly unscathed so far, but beneath the surface there has been more pain. At the time of writing, the S&P 500 had only fallen 4% from its peak, but this has been buoyed mainly by the resilience of Apple, the largest stock in the index, which remained in positive territory. However, on an equally weighted basis the S&P has fallen over 6.5% and the Russell 2000 over 12% peak to trough. It seems certain stocks also underwent a ‘Black Friday sale’, with Tesla and Meta (Facebook) down close to 10%. The percentage of stocks above their 50-day moving average has plummeted from 75% to below 23%, the lowest reading since March 2020. The reopening theme has been spun on its head, most notably in the 22.5% collapse in WTI oil prices, as investors quickly flip from euphoria to a more defensive positioning.
We won’t know for a while whether the new variant is more deadly or more resistant to vaccines than Delta, so it’s hard to tell whether the market is over or underreacting to this news. Current data suggests the transmissibility (R0) is settling around 3-4 in South Africa and its ability to evade antibodies appears higher. On the positive side, cases appear mild, and vaccines appear to protect against hospitalization. We are still wading through the unknown, but the data will become clearer in the following weeks. However, if the Delta experience is any roadmap, the market could quicky look though the current uncertainty and continue powering ahead once uncertainty is lifted. For now, we believe new strains are a part of life and investors should expect bouts of volatility for the foreseeable future.
US path forward
One potential positive was the belief that Omicron may provide the Federal Reserve cover to tilt more dovish, given their recent hawkish commentary. A new variant which may lead to new lockdowns or slower global growth would be a counterbalance to current inflationary pressures. However, Powell instead told Congress it was time to retire the word “transitory” when discussing inflation and said he was open to a faster liquidity withdrawal via a reduction in bond purchases. His testimony was viewed as more hawkish than expected and increases the chance of earlier rate hikes.
The Fed is under increasing pressure from Congress to ‘do something’ about inflation given the punitive effect it has on Main Street. However, if a new Covid strain wasn’t sufficient, we may have to wait for a more serious economic slowdown or market correction before Powell changes course. This liquidity withdrawal from the Fed will likely come at the same time Congress lifts the debt ceiling and Treasury unleashes a tidal wave of bond issuance to finance its deficit; we expect somewhere between US$500bn to $1trn of new issuance. This all leads to a sharp reduction of liquidity while heading into a potential economic slowdown. We see this is perhaps a more clear and present danger than the still unknown impact of Omicron.
We started to become more concerned with risk assets early in the month. US inflation data continued to print higher than expected, with the CPI hitting 6.2% YoY. This was enough to see yields on the US 10-year bonds rise 20bps to over 1.63% in less than a week. Given high valuations in equities we decided to reduce our equity allocation in mid-November. Most of the reduction came from selling our US equity call option position, which reduced our exposure by 5% before the sell-off. We were also positioning our portfolio for higher rates by reducing our duration by 0.25yrs, focusing on shorter maturities where upward pressure on yields is higher. After cutting our global high yield exposure to zero over the third quarter after spreads continued to compress to historic lows, we took advantage of the sharp move wider in spreads caused by the Omicron news. With valuations moving to more neutral territory we removed our credit derivative hedges as spreads rose from 275 basis points to 330 basis points at the end of November.
While we believed markets were too complacent ahead of Omicron, until we know more about this variant it is hard to judge whether the recent scare is overblown or in its infancy. What we do know is that volatility is likely to remain a feature of this market, considering that more mutations are all but assured until the world builds significant resistance to the virus through higher vaccine rollout to developing countries. In the meantime, we remain cautious that liquidity will move from a tailwind to a headwind under a more hawkish Powell, and it may take a market shock for him to change course given political pressure. In the medium term we do believe equities remain one of the favoured asset classes to deliver returns given their continued earnings growth and ability to defend margins – although we have reduced our allocation given the expected volatility ahead.
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