Have Omicron fears been overplayed?

December 03, 2021

With much still to learn about this new variant, we’re wondering if the price action can really be justified by the newsflow.

News of the new Omicron variant sent markets into a tailspin at the end of last week. A flight to quality ensued on fears that a vaccine-resistant variant would lead to a material setback in the economic recovery, which has been gathering momentum as we have progressed through 2021. Government bond yields rallied, with corporate and sovereign credit spreads coming under pressure and leaving index spreads wider than where they traded at the start of the year.

However, as we take stock several days later, it seems appropriate to question whether this price action can be fully justified by the newsflow. At this stage, it seems that there is still much we don’t know about Omicron. However, early data from South Africa and elsewhere have suggested that, although the new variant may be more transmissible than the Delta version, hospitalisation rates are not picking-up nearly as quickly.

On this point, so far only 2% of Omicron cases have led to hospitalisation one week later, compared to a 10% hospitalisation rate during the Delta wave. If this trend is substantiated over coming days, then it could suggest that symptoms in this variant may be milder than in other strains, or that vaccines continue to be highly effective in preventing severe illness, or both.

It also seems as if Omicron has already spread globally and is circulating within the community in many countries. In that context, we have sympathy for medics in South Africa, who identified the strain, only for the country to suffer pariah status. Indeed, analysis of sewage data appears to substantiate that Omicron has been around for some time, meaning early estimates of the ‘R’ number have been over-estimated.

In the face of the news on the virus, steps to accelerate vaccination and booster jabs appear to make good policy sense. However, the re-imposition of lockdown restrictions could be a policy mistake, in our view, if it undermines vaccine confidence.

Policymakers may argue that it makes sense to act out of an abundance of caution, yet scare-mongering could become counter-productive.

Globally speaking, it has also been interesting to contrast a very measured response to virus news in the US compared to greater fear-mongering across much of Europe. This leads us to think that US growth exceptionalism could continue to be a dominant theme into 2022. Meanwhile, it has been interesting to observe the Federal Reserve largely dismiss virus risks for the time being, with Powell signalling a pivot to faster tapering of asset purchases and earlier rate hikes at the Congressional Testimony alongside Janet Yellen this week.

For some time, we have been arguing that it was wrong to label all the inflation we are observing as ‘transitory’ and are pleased to see the Fed coming towards our views.

US inflation has become politicised in recent months. As we enter 2022, it is clear that the Fed needs to bring price pressures under control, as the labour market continues to tighten against the backdrop of structurally lower levels of participation.

However, financial markets remain sceptical that rates can rise by very much without impairing the economic outlook.

Consequently, long-dated yields have tended to decline, even as short-dated rate expectations push higher. Yet it seems highly questionable to us that this will prove to be the case and we believe that interest rates can rise a material amount well before monetary policy becomes restrictive – especially noting that real interest rates remain in deeply negative territory for the time being.

We have been frustrated not to witness yields rise, even as our projections for growth, inflation and monetary policy have been largely fulfilled over the past year. But we continue to believe that there will be a moment in the weeks ahead where we witness a transition to a higher yield regime and feel that it remains appropriate to adopt patience with respect to this view.

In Europe, our assessment is more downbeat. To-date, low levels of cumulative deaths from Covid in countries such as Germany, relative to the UK, Italy or the US, point to lower levels of acquired immunity to Covid and this may make a lockdown more likely, as the share of ICU beds taken by Covid patients continues to climb.

Against this backdrop, we believe that the ECB has the cover to continue to remain accommodative for now, even if the hawks we are hearing from on the Governing Council are highlighting overshooting inflation as a reason not to extend PEPP or add to APP. We think that it could be premature for the ECB to surprise on the hawkish side at this particular juncture, although this may be the direction of travel as we move through 2022.

In the UK, the Bank of England is also likely to defer policy tightening in December, though we expect inflation pressures to build as the MPC sits on its hands. A lockdown seems very unlikely in the UK, though government messaging could dent consumer and business sentiment over the coming month.

From an FX standpoint, we continue to favour the pound to weaken versus the US dollar.

Emerging markets have come under pressure in the past few weeks, though cheaper valuations should help to limit further weakness. The situation in Turkey remains very fragile as markets take on Erdogan and his unorthodox policy stance with respect to keeping interest rates low in the face of accelerating inflation pressures.

Elsewhere, countries that have adopted a more orthodox approach appear closer to stabilising price pressures. This may make for a more favourable backdrop for local rates in 2022, as long as trends from the US do not contaminate the picture. From a Covid standpoint, it has been interesting to see how, despite Delta becoming the dominant variant in Brazil, there has been no associated Delta wave, with the acquired immunity from the prior Gamma wave acting to insulate against that.

In this way, countries that have already been hit by the worst of Covid may have little to fear from future waves, while countries that have remained isolated in the battle to keep Covid out face the inevitability that they will experience climbing numbers any time restrictions begin to be lifted.

In corporate credit, valuations are also more compelling than has been the case all year and recent weakness has offered the opportunity to add to favoured names and close CDS hedges. An accommodative ECB should remain relatively supportive for credit spreads in the region, and we see seasonal factors as a positive in the second half of December and early January.

A more hawkish Fed could be a greater threat to US spreads, but only if rates rise far enough to start to raise implied future recession risks. We think we remain a very long way from that point just yet.

Looking ahead

The coming week should give us much more news with respect to Omicron and its likely impact on societies, economies and financial markets. We are wary of potentially negative news in Germany, but away from this are hoping that analysis continues to confirm that many of the fears expressed around Omicron have been largely overplayed. We have been learning to live with the virus and we doubt this will change.

We would conclude that the impact of Omicron should be more temporary and less severe than has been the case with the Delta wave this autumn. If this is correct and we are also right in our views that US data will remain firm, then we think it is right to expect the Fed to confirm its hawkish pivot when it meets next month.

In that case, we think that we may have seen the lows in Treasury yields during this move and that there will be scope to generate positive performance as we finish the year.

Indeed, we may even be hopeful that if Omicron is less severe than previous variants of Covid, then we could actually witness an acceleration away from the pandemic as this becomes more widely appreciated.

We certainly hope that this will be the right call…and for reasons that extend far more broadly than portfolio management.

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