The emergence of the new Omicron COVID-19 variant sent markets into a nervous tailspin, causing a sell-off toward the end of the month and erasing earlier gains. While nearly all global equity indices performed poorly, ex-US equities experienced the most outsized losses, with the MSCI Emerging Markets Index falling 3.2% and MSCI Europe Index losing 2.3%. Australian equities were relative outperformers, with the ASX200 falling only a modest 0.5%.
Hawkish comments from Jerome Powell caused yield curves to flatten as investors brought forward their expectations for a rate hiking cycle. Longer-dated yields rallied as investors sought comfort in safer haven assets amid the Omicron-induced volatility, resulting in the US 10-Yr Treasury Yield falling 12bps to 1.44% and the AU 10-Yr Government Bond yield falling 38bps to 1.70%.
The Australian Dollar was weaker across the board. Relative to the US Dollar, the local currency slid 5.6% over the month and now buys 71 US cents. Commodities were also generally weaker given fears of potential slowing demand in the wake of the new virus strain. Crude Oil markets softened as the US announced intentions to release oil from its strategic reserve to combat higher prices, with Brent Crude dropping 15% to $70/bbl (Chart 3). The price of Iron Ore dropped 21.7% to $95/bbl. On the other hand, Gold was 2% higher to $1,804/oz.
Omicron – the known unknown
While scientists and health professionals are still assessing the potential dangers of Omicron, the emerging threat of a new variant caused fixed income and equity markets to tumble. The US 10-Yr Treasury yield dropped the most since March 2020, while most equity markets, as well as oil prices, fell after the official confirmation from the World Health Organisation that Omicron was “a variant of concern”, its most serious category.
Presently, Omicron is a known unknown for financial markets. Should the variant turn out to be milder than feared, it would likely have a short-lived impact on financial markets. However, if the latest variant poses a more severe risk due to its transmissibility and ability to evade vaccine protection, a more cautious stance towards risk assets may be warranted. In this scenario, the likely outcome would be a slowdown in economic activity and a period of weakness across global equities markets. However, a significant deterioration in economic activity would also lower inflationary pressures, which would reduce the pace of monetary tightening, thus smoothing out the longer-term impact.
There is not yet enough information to conclude that the emergence of the Omicron variant justifies a change in the outlook for risk assets. As stated by US President Biden, Omicron is a “cause for concern, not panic”. Investors should stay put until more information is known about the likely impact of the latest COVID-19 variant.
Powell retires “transitory” inflation
It wasn’t only financial markets that seemed to pivot in November. After spending many months reassuring market participants that any tightening to monetary policy would occur at a very gradual pace, the Federal Reserve Chairman Jerome Powell upended markets with what was perceived to be a hawkish shift in the Fed’s approach. In an appearance before a Senate committee, the Fed chief said he thought reducing the pace of monthly bond purchasing could move more quickly than the $15 billion per month schedule announced earlier this month. Powell also mentioned that the emergence of the Omicron variant had raised the uncertainty around inflation. Mr Powell has called recent high inflation rates transitory, a term he said should now be “retired”.
The faster tapering could impact two significant narratives. First, it decreases support for equities by removing monetary accommodation sooner. Secondly, it indicates that the Fed doesn’t see inflation easing in the coming year and considers Omicron a non-material threat to economic recovery. While this shift does suggest that the Fed’s first interest rate hike could occur earlier than previously expected, it is too early to draw any conclusions before we see the full impact of Omicron on economic activity and inflation. Even if the Fed does hike earlier, the base case scenario is for monetary policy and financial conditions to remain accommodative over the medium term, which would continue to provide a positive backdrop for equities, albeit with lower expected returns.
Although November’s market turmoil showed how dependent the financial markets had become on the path of the pandemic and how quickly the sentiment could change, we made no changes to our medium-term views. While the Omicron variant is a source of uncertainty, which could cause a flight to safety over the near term, we could still see a reversal in many of November’s market actions.
We remain constructive on equities over the medium-term, which remain attractively priced relative to bonds, and are likely to continue generating positive returns. The excess return of stocks over real bond yields stands at 5.86%.
Structurally higher inflation over the long term continues to present a risk to portfolios that is unlikely to dissipate. Therefore, we continue to make allocations to property, infrastructure, Gold and other commodities to maintain inflation hedging and portfolio diversification.
We continue to see government bonds as largely un-investable and expensive. We prefer various alternative investments that add some downside protection to portfolios whilst also helping achieve income and growth targets.
In times of elevated uncertainty and increased volatility, remaining disciplined and focused on long-term investment objectives is important. As market volatility is likely to persist over the next few weeks, before we have more reliable information on the potential impact of the Omicron variant, we advocate for a patient approach to implementing new investments. We also encourage having dry powder available should there be opportunities to add to portfolios at relatively more attractive valuations. Over the long term, diversification across asset classes and investment managers should minimise the impacts of this volatility on portfolios.
We encourage you to contact us should you wish to discuss this further or if you have any questions about how these trends are impacting your portfolio.