What Omicron Means for the Markets
Despite bellies full of leftover turkey and stuffing from Thanksgiving, the markets have been anything but slow the last week. From South Africa’s discovery of the COVID-19 Omicron variant to Fed Chair Jerome Powell’s commentary around inflation and tapering slowdown, markets have continued to digest dynamic news in the days following Thanksgiving. We thought it worthwhile to share our thoughts, and welcome yours, as we enter this holiday season while setting course to navigate what is anticipated to be a stormy December.
Omicron adds another potential impediment to US (and global) growth over the near-to-medium term. However, it is important to note that growth forecasts (including ours) have been revised downwards over the summer, factoring in weaker economic momentum in China but also continued disruptions from COVID-19. Omicron introduces a new strain to the latter driver. Last Friday’s news of the new variant prompted investors to dust off their pandemic playbooks (selling risk assets and increasing allocations to Treasuries), which seemed eerily reminiscent of Q1 2020’s outsized volatility. Indeed, 10-year yields registered their largest one-day decline1 since March of last year (~16bps), while investment grade credit indices widened the most in over a year (~4bps). While the weakness in investment grade credit was broad based, the unsurprisingly reopening of sensitive sectors (e.g., airlines, energy) and emerging market exposed sectors (sovereigns) were laggards.
Over the last few quarters, we have argued that historically tight spreads failed to adequately compensate investors for burgeoning risks to the outlook. In our view, one of the foremost risks on the horizon has been the Fed finding itself behind the curve and being forced to raise rates faster than anticipated due to elevated inflation and an overheating economy. A more aggressive reaction function from the Fed would likely lead to an increase in volatility and serve as a catalyst for pushing spreads wider. How does the news of Omicron potentially change this view? Early returns suggest that investors generally believe that the variant increases the likelihood of a return to lockdown, depressed economic activity and consequently reduced inflationary pressures. However, we also wouldn’t discount the risk of potential upside pressures on inflation stemming from an intensification of supply chain bottlenecks and the need to increase wages further to lure people back to work.
In his testimony before the Senate Banking Committee on Tuesday, Powell confirmed that they expect current levels of inflation are here to stay at least into next year. He warned that the emergence of Omicron and escalating concerns over the new variant could prolong supply-chain disruptions that have recently pushed inflation higher. He suggested that tapering could be accelerated, introducing the idea of ending bond purchases earlier than next summer.
At LGIM America, we are exercising caution in extrapolating 2020’s outbreak as a blueprint for how the fallout from Omicron might play out, as there are important distinctions between then and now. Most importantly, today we have vaccines that have shown efficacy in limiting the adverse impacts of the virus. It is also important to note that while the virus is spreading quickly in South Africa, the vaccination rate in South Africa is significantly lower than developed economies. Additionally, BioNTech, Moderna, Johnson & Johnson etc. have all come out expressing confidence that they can adapt their shots to address the latest strain in relatively short order. Lastly, it is encouraging that scientists have observed only mild side effects in patients thus far, despite the fact the strain appears to be more infectious.
As we head into year end, we continue to advocate for a defensive bias in credit portfolios; however, we are using this pullback in spreads to opportunistically reduce our Treasury position and add risk at more attractive levels via the new issuance market. Our preliminary view is that we are unlikely to see the magnitude of economic disruption seen in 2020 due to the widespread circulation of vaccines and lockdown fatigue, particularly in the US. The extent of the threat posed by this strain should become more apparent in the next few weeks, and we stand ready to adjust portfolios quickly should conditions warrant and as Fed policymakers meet again two weeks from now.
1. November 26, 2021.
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