Bedrock’s Newsletter for Friday 3rd December, 2021

Posted by Honey Soleymani on 3rd December 2021

Friday 3rd December, 2021

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Since the Omicron variant was first identified by South African scientists last week, its rapid spread has sent shockwaves through financial markets and driven a steep re-pricing of risk assets. The variant was actually reported to the World Health Organisation (WHO) on Wednesday, but it was not until Friday that markets got wind of the discovery – and investors bore the brunt of the bad news. By the close of trading, the S&P 500 Index was down -2.3% for the day and the MSCI Emerging Market Index was down -2.5% (in USD). Meanwhile, in Europe, where countries are already battling against a huge wave of the Delta variant, the benchmark Euro STOXX 600 Index was down -3.7% on Friday, its largest one-day drop since the sell-off in March 2020. Cyclical commodities also had a tough session, with WTI (US onshore) oil and Brent crude futures collapsing -13.1% and -11.6%, respectively. (This move has since been exacerbated by the OPEC+ group deciding to press ahead with a >400K bpd production increase, and after a group of major countries released their strategic oil reserves to address energy shortages this week.) Meanwhile, 10Y treasury, bund, and gilt yields fell -16bps, -9bps, and -15bps on Friday, as expectations for central bank QE tapering and rate hikes were pushed out some distance.

 
Since the Friday sell-off, investors have been scrambling to interpret a barrage of speculative and often inconsistent information about the variant, driving significant price volatility and sharp intraday moves across markets. Little is known for certain about Omicron, but its heavily mutated spike protein (which the virus uses to enter host cells) suggests that it may be able to evade at least some of the immunity conferred by our current crop of vaccines; a point made by Moderna’s CEO, much to the benefit of his company’s stock! Meanwhile, the wildfire spread of the variant in South Africa (where cases are surging on an exponential trend) suggests that we are probably dealing with the most infectious strain to date. And, despite much of the world ‘red-listing’ the country and its neighbours within a few of hours of the discovery, Omicron has now been detected on all continents except for Antarctica… Déjà vu, anyone? Omicron is the guest that no one invited this Christmas, seemingly determined to spoil the festive mood for yet another year; and it has already upset the Santa Rally that we all hoped would carry us in to 2022.

 
Having burst on to the scene and upended the prevailing narrative in a matter of days, the advent of Omicron should serve as a less-than-gentle reminder that the coronavirus pandemic is far from over. It is also proof that tail risks should not be ignored when making investment decisions just because it is easy to do most of the time. We do not yet know how deadly Omicron will turn out to be (and there are many anecdotal reports that the symptoms of those infected by the variant are fairly mild). But covid-19 restrictions are almost certain to be tightened up in those countries which have not already battened down the hatches this winter. And this is bad for growth and the world. On the subject of new coronavirus measures, Germany – which is experiencing its worst wave of infection so far – has now followed Austria in barring the unvaccinated from non-essential shops, restaurants, and other entertainment venues; and the government has also announced that vaccination will become mandatory from February 2022. This decision is backed by the EU Commission President who mooted an EU-wide mandate this week, as well as by the German opposition coalition that will replace Angela Merkel’s CDU government under the SPD’s Olaf Scholz next year. There is hope that the booster programme which is being rolled out across Europe will provide some relief in the coming months (as it has done in the UK), but the trend is still strongly towards tighter restrictions now.

 
So where might this new variant and tougher social distancing policies take us? Do tighter restrictions, mean looser government and central bank policy? What about the risk of inflation? And how should one position investment portfolios?
 
Starting at the top, then, restrictions on economic activity (whether they are employed to halt the spread of Omicron or Delta) will carry an economic cost (via recession, increased indebtedness, or both). No one still advocates a return to 2020-style blanket lockdowns, but slower growth will result if people are told to stay at home. That much is clear. Last time around, the associated demand shock required an enormous fiscal and monetary stimulus to offset it, as well as emergency legislative and fiscal support for impacted firms and households. These measures did not come cheap, but the recipe seems to have been a success overall. And, as the recovery gathered pace this year, some policies (e.g., job support schemes) were wound up to control ballooning government debts. If restrictions are tightened again in the coming months, central banks and governments will obviously want to repeat the winning formula. But there is an issue of policy space… We are much more indebted than we were before the pandemic, and inflation is running hot – really hot. Both of these issues would be made worse by fresh stimulus measures, and this will be top of policymakers’ minds when they come to write legislation. That said, unless the bond market now has a tantrum over debt sustainability (which is rather unlikely when central banks are the biggest bond holders of all) concerns about excess debt levels can be kicked into the long grass – and therefore almost certainly will be. But inflation cannot be ignored.

 
Indeed, we had a raft of new data out of Europe this week, and it is bad news for those who are sanguine about inflation. In Germany, preliminary data show that headline prices rose +6.0% YoY in November, while in France and Italy, they were up +3.4% and +4.0%, respectively. These readings have translated into a Euro Area inflation rate of +4.9% (vs. 4.5% expected), the fastest pace since the currency union was established in 1999. However, when you consider that producer prices inflation (PPI) reached +21.9% YoY in November (driven by a +62.5% YoY increase in energy prices) this should come as no surprise. Indeed, it is a marvel that consumers have not been hit harder! The president of the European Central Bank (ECB) has said that she sees inflation as a passing ‘hump’ that would likely decline next year. A hump it may be, but when does a hump become a hill – or a mountain? In our view this will depend heavily on where the pandemic heads next…

 
Inflation is also proving a lot more persistent than was initially forecast in the US. We do not have the November print yet, but headline inflation soared to +6.0% in October, and no slowdown is expected to have occurred in recent weeks. There is evidence that this inflation is already biting into corporate profits and household budgets and causing consumer confidence to deteriorate; and such problems will only become more acute if no action is taken. More structurally, the biggest risk is if high inflation becomes the norm, expectations shift, and we get trapped in a spiral of rising prices. The only way out of such a scenario would be much higher policy rates in future, which would hurt the economy and bring the debt sustainability question back to centre stage. Governments and central banks need to be more cautious today than they were in 2020, given the changed macro backdrop. And this is why Fed Chair Jerome Powell signalled a hawkish turn this week, highlighting the need to pursue a faster tapering of QE than previously suggested. He knows that failing to act could create serious problems down the line… but he will be faced with few options if coronavirus restrictions return.

 
And should restrictions return for some time, this could itself create more inflation. In our last newsletter, we suggested that price pressures have a lot to do with supply chain dislocations, a shift in spending patterns (from services to goods), underinvestment in CAPEX amid the uncertainty brought on by covid-19, and labour shortages (as workers fearful of the virus choose to remain at home rather than return to work, despite higher wages and benefits to tempt them back). All of these causal factors would be exacerbated by new restrictions on international and domestic mobility. And together with a delayed tapering of QE, or even fresh fiscal and monetary stimulus measures to support the economy through a socially distanced Christmas, this could mean even higher inflation next year.
 
So, what does this mean for portfolios? In short – buy inflation hedges like commodities and real assets, steer clear of long-duration fixed income, ride the liquidity while it lasts, and stay diversified to weather the uncertainty. Seems simple enough.