In October, we wrote that markets had “put aside much of their concern about the immediate risk of another serious COVID-19 setback” and were focused on cyclical threats of slowing growth, rising inflation and tighter monetary policy. As such, many of our recent Perspectives—from Brad Tank and the fixed income team, from Erik Knutzen and, last week, from Robert Surgent—have addressed these issues rather than the tail risks of the pandemic.
The volatility of the past two weeks, coinciding with the emergence of the Omicron variant of SARS-COV-2, might be seen as challenging this view. But we don’t see it that way. We still believe much of this has more to do with growth, inflation and Fed policy uncertainty than anything else—which suggests that the jitters are likely to keep on coming beyond the Omicron scare and into 2022.
Cautious vs. Overcautious
To be sure, the pandemic is still with us. New infections have been rising globally for the past two months. The discovery of the Omicron variant, which, based on early evidence, appears to be more transmissible and possibly more resistant to vaccinations and inoculations, is cause enough for caution.
But the early evidence also suggests that vaccines and antiviral treatments are still effective against severe COVID-19. Importantly, while it is still early in the evaluation process, the new variant appears to cause less severe illness—and global dominance by a less virulent strain could potentially bring forward an end to this crisis.
Overall, in a post-vaccine world, few market participants seem to fear a full-scale, protracted, 2020-style lockdown. The worry is more that governments might be overcautious in their temporary restrictions, thereby slowing down progress in supply chains and exacerbating a cyclical inflationary slowdown that was already in many investors’ peripheral vision.
It is notable that the emergence of Omicron coincided with a significantly hawkish change of tone from the U.S. Federal Reserve.
On Tuesday November 30, Fed Chair Jerome Powell “retired” the “transitory inflation” terminology that we have become so accustomed to, and suggested that the completion of asset-purchase tapering might be brought forward by “a few months.” The Fed’s essential admission that it was wrong on inflation, while somewhat obvious, took the market by surprise.
We believe this exacerbated the volatility. Equity markets hit their recent lows as they digested his words. After months of worrying about the policy mistake of tightening too slowly in the face of rising inflation, investors were suddenly worrying about the opposite policy mistake: tightening too fast in the face of a genuine threat to the growth recovery. A decidedly mixed U.S. payrolls report on December 3 that showed disappointing jobs growth but a big drop in unemployment and a rise in the participation rate only reinforced the sense of uncertainty about the recovery. Rates markets pushed their estimate of the first hike further out into 2022.
By last week, however, they had more than reversed that move: The market odds of a hike in May are now higher than they were pre-Omicron. It seems unlikely this was only or even mainly to do with Omicron news. It was more likely due to investors bracing for yet another big U.S. inflation print, which came in on Friday at 6.8%, the highest rate of year-over-year growth since 1982, and settling into the assumption that the Fed will follow through on Powell’s words this week and accelerate tapering.
A Significant Transition
As we look through the Omicron fog we see the underlying cyclical questions. Where is growth going? Where is inflation going? How might central banks respond? And, ultimately, how much policy-tightening, and at what speed, can Treasury and equity markets bear?
The Fed remains, in our view, the key variable. Equity markets, by and large, can tolerate inflation as long as the Fed tolerates inflation. As soon as the Fed moves hard, markets usually react violently.
The answers to these questions remain uncertain—which is likely the reason for the current volatility, and why it could well persist deep into 2022. What we are more certain about is that, at current market valuations, the strip for a smooth landing is very narrow. Over the past three years the S&P 500 Index is up more than 20%, annualized, a run rate that isn’t sustainable.
We believe that vaccines made 2021 a year of significant transition in the pandemic. As we have argued in many of our recent Perspectives, next year also looks likely to be a year of significant transition—but this time, due to the likely shift in Fed policy.
In Case You Missed It
- Eurozone 3Q 2021 GDP (Final): +2.2% quarter-over-quarter
- Japan 3Q 2021 GDP (Final): -3.6% annualized rate
- U.S. Initial Jobless Claims: +184,000 for the week ending December 4
- U.S. Consumer Price Index: +0.8% in November month-over-month and +6.8% year-over-year (Core CPI increased 0.5% month-over-month and 4.9% year-over-year)
What to Watch For
- Tuesday, December 14:
- U.S. Producer Price Index
- Wednesday, December 15:
- U.S. Retail Sales
- Federal Open Market Committee Meeting, Summary of Economic Projections and Press Conference
- NAHB Housing Market Index
- Japan Purchasing Managers’ Index
- Thursday December 16:
- U.S. Initial Jobless Claims
- U.S. Housing Starts & Building Permits
- U.S. Purchasing Managers’ Index
- Eurozone Purchasing Managers’ Index
- Eurozone Central Bank Policy Meeting
- Bank of Japan Policy Meeting