OMICRON BTFD?

Goldman is cautious:

With Omicron uncertainty continuing to weigh heavily on markets amid an already sharp pickup in COVID cases, we assess the risks the new variant presents to global (andEuro area and UK) growth. We estimate that a downside scenario in which the variant transmits more quickly and evades immunity against infection more than Delta, but leads to only slightly higher hospitalizations than Delta, would tighten our Effective Lockdown Index (ELI) to a similar degree as the Delta wave, as shown inour chart of the week, which would be sufficient to slow global growth to a 2% qoq ann. pace in 1Q22, or 2.5pp below our current forecast. But we estimate an ambiguous inflation impact in this scenario, as global services and energy inflation would likely be lower, due to weaker demand, and goods inflation higher, as a resultof weaker supply. That said, both more extreme downside and upside scenarios are possible, and we caution that the range of medical and economic outcomes remains unusually wide at the moment given the remaining unknowns around the transmissibility, degree of protection from vaccines and prior infections, and disease severity of Omicron

JPM is bullish but then it always is:

Over the last several days markets have been in turmoil over the new COVID variant Omicron. However, data on Omicron is sparse, information contradictory, and some media has been exaggerating risks and highlighting worst case scenarios. South African health officials are not nearly as alarmed and are reporting predominantly mild cases (here). The WHO is fairly neutral (here). Current data does not appear alarming as of this time – South African cases are near the pandemic average (49th percentile), and COVID fatalities are near the bottom (4th percentile) – a fairly favorable situation relative to past 2 years (and significantly better than the rest of the world where the cases are in the 64th, and deaths in the 17th percentile).

What was the timeline and how did the market react on the Omicron variant?

Despite Omicron being around for several weeks, a media blitz happened on Thanksgiving evening, one of the lowest points of market liquidity for the whole year, prompting a crash in various assets sensitive to global growth and recovery such as Oil. A second blow to markets was delivered shortly after, also in the middle of night in the U.S. (Monday midnight), with the Moderna story that was later largely invalidated by reports from Pfizer, Oxford, the WHO, and the Israeli Health Ministry.  Many clients have told us they are not worried about Omicron itself, but the reaction of governments. For example, currently flights are restricted from several African countries that don’t have Omicron, while on the other hand, flights are not restricted from European countries that have cases, and similar apparent inconsistencies.

Another source of confusion comes from assessments of Omicron’s transmissibility. Broadly circulated claims that the new variant is 500 times more infectious than Delta (here) seem implausible. For instance, assume that R0 for Delta is 4, so Omicron would have an R0 of 2,000, meaning one infected person should result in 2,000 new infections? This is highly unlikely when on average an individual has 16 daily contacts (here), and, by that math, the whole world would have been already infected in less than a week (i.e., 3 cycles would result in 20003 = 8Bn infections). This figure came from extrapolating transmissibility from relative spread of Delta and Omicron, but not accounting for the fact that Delta is being spread in significant part via breakthrough infections in a significantly immune population (e.g., via vaccines or recovery). In simple terms, when older variants are spreading via breakthrough infections, new variants will always appear to be significantly more transmissible than older ones. This was explained in work by Gabriela Gomes (e.g., see here).

While it is likely that Omicron is more transmissible, early reports suggest it may also be less deadly – which would fit into the pattern of virus evolution observed historically. Should these trends be confirmed in the coming weeks, could the Omicron variant ultimately prove to be a positive for risk markets, in the sense that it could accelerate the end of the pandemic? If a less severe and more transmissible virus quickly crowds out more severe variants, could the Omicron variant be a catalyst to transform a deadly pandemic into something more similar to seasonal flu? That development would fit with historical patterns (duration and number of waves) of previous respiratory virus pandemics, especially given the broad availability of vaccines and new therapeutics that are expected to work on all known variants (Pfizer, Merck). If the market were to anticipate that scenario –
Omicron could be a catalyst for steepening (not flattening) the yield curve, rotation from growth to value, selloff in COVID and lockdown beneficiaries and rally in reopening themes. Also, if that scenario were to happen, instead of skipping two letters and naming it Omicron, the WHO could have skipped all the way to Omega. As such, we view the recent selloff in these segments as an opportunity to buy the dip in cyclicals, commodities and reopening themes, and to position for higher bond yields and steepening.

I am leaning towards the OMICRON benign scenario even if it’s too early to sure. That said, we do not see that outcome in the same way for assets. The Treasury curve has been flattening since the Fed turned hawkish and with China still slowing sharply and Europe to follow there is no reason to expect that to change.

Lombard is also pretty sanguine:

Short term: uncertainty and market volatility will prevail. Omicron is dominating headlines and market price action. The main concern is that the new variant is more infectious and has many mutations of the spike protein, which could render current vaccines ineffective. However, there have also been headlines indicating that Omicron is less lethal and its greater transmissibility could be positive as it replaces more lethal variants as the dominant strain. BioNTech has said it will take a couple weeks to see if existing vaccines are effective. In the short term, uncertainty and therefore market volatility will continue until we get greater clarity on the resistance to vaccines and the lethality and transmissibility of Omicron. In this environment, we prefer to position in relative value trades.

Omicron: we have been here before and the market knows it. This is not the market’s first rodeo: the WHO lists four “variants of concern” – Beta (first from South Africa), Gamma (Brazil), Delta (India) and Omicron (South Africa again). At one point or another, they have all been a source of anxiety – with varying severity – for the market. The Beta variant was first discovered in September 2020, at which point news stories spiked dramatically (chart bottom left). Throughout that month, more restrictions were imposed globally, as the second wave hit and many developed nations headed into winter. Uncertainty increased as the 2020 US election approached.

Nonetheless, once the election was over in November (with increased chances of further fiscal expansion) and as expectations of a vaccine in the New Year heightened, risk assets shrugged off elevated numbers of COVID cases.

When the Delta variant began to dominate headlines in June 2021 (although it was first discovered in December 2020), risk assets wobbled throughout June and July. But the market had already learned its lesson; and since vaccines were widely distributed in many DMs and a return to complete lockdown unlikely, the pressure on risk assets was short-lived.

In the here and now, the lead times to vaccine manufacture/distribution are short (Moderna has said it could have one ready in early 2022), the majority of developed market populations are vaccinated and public sentiment has turned sharply away from wide-scale lockdowns. In view of these developments along with the abundant stock of global liquidity and corresponding buy the dip market mentality, we are unsurprised by tentative asset recovery on Monday and Wednesday of this week and we expect the impact of Omicron to fade in the medium term.

That is not to say Omicron will have zero impact. We have long been of the view that COVID would be manageably endemic (the WHO already has more than 20 de-escalated variants); and for this reason, we believe Omicron is just the latest wobble. Before Omicron’s emergence, travel restrictions and lockdowns were being maintained or implemented in some regions in response to rising COVID cases (chart top right). Omicron raises the probability that more restrictions are imposed, which would have a larger negative impact on growth.

The impact is unequal and will be felt more in the EU & EMs than in the US. COVID hurts growth and therefore earnings and equities because it limits activity. This impact is felt unevenly across countries partly because they have widely differing COVID response functions. In the US there is very little appetite to go back into any type of lockdown. President Biden has already come out strongly against using lockdowns in response to Omicron and said the nation’s response will be more vaccinations. By contrast, Europe was already imposing lockdowns before Omicron, while some EMs are still implementing zero-covid policies (notably China). Since valuations are still elevated, earnings need to do the heavy lifting from here; that task has now become harder in the EU and EMs relative to the US.

The US has outperformed over the emergence of variants in the past and will do so again. The market is aware that the EU & US have differing sectoral exposures to COVID (see below for more details), differing response functions to COVID and thus diverging growth and EPS implications on the emergence of COVID scares. When the Beta and Delta variants became market concerns, the US markedly outperformed (see chart above). That pattern has repeated with Omicron. We think the current trend has momentum, but we like this trade because of our view that the virus is becoming manageably endemic; the chances are more likely than not that there will be another COVID scare.

Assuming we do get through OMICRON unscathed, I am still concerned about the mid-cycle slowdown. The Fed is going tighten directly into a slowing China that is still not stimulating with any vigour and Europe’s reopening boom is set to stall in 2022.

BTFD does not appeal with markets so out of balance, Nomura captures it:

  • So what really changed?  It’s pretty obvious: the Fed has green-lighted an accelerated taper in order to pull-forward a dense-but-short “lift-off,” as Jerome Powell is clearly now much more concerned about inflation (which is no longer transitory) than about economic growth
  • And with that, Inflation proxies  / forwards have been crunched (5y5y 2.41 to current 2.18, 5Y BE’s 3.20 to 2.71) and resetting Real Yields (5Y RY skyrocketing from -1.95 to -1.54 in 2.5 weeks) in a pure “tightening of financial conditions” fashion, as the market pulls-forward the slowdown impact of the Fed’s policy actions
  • This is when I go back to the Nomura “Economic Quadrant” playbook—bc the current Equities risk-prem / thematic return profile very closely mirrors what we said it would do upon this the phase shift from “Expansion” into “Slowdown” being confirmed in the first week of October (and holding since)—see below for the 3m forward return backtest when in static “Slowdown” quadrant, as well as the “transition from Expansion to Slowdown” 3m returns:

Source: NSI, Bloomberg as of 1 Dec 2021. Past Performance Not Indicative of Future Results. This Is For Illustration Purposes Only

  • So taking this idea of “accelerated tightening” from the Fed…could that also then too see this artificial economic cycle then experience an accelerated move into the NEXT potential quadrant shift, from “Slowdown” into “Contraction”?  And what would that mean for Factor fwd returns on both a static- and “transition into-“ cut?
  • We see two very different stories being told, depending on whether we are talking “static” returns when immersed in the “Contraction” phase, versus the “transition into” returns on the backtest from “Slowdown to Contraction”
    • It looks like during the initial phase-shift “transition” that the market actually begins to anticipate the hard economic “stop”…and with that will come policy-makers turning their efforts to “easing”—so you see “economic growth / inflation -sensitives” being to perform like “10Yr Yield Factor,” “WTI Crude Factor,” “Growth Nowcast Factor” and “Cyclical Value Factor” lead 3m out as traders sniff policy rate “cuts
    • HOWEVER, upon immersion with the “Contraction” phase, it is clear that there is a very rational “risk-off” phase, with leadership from “Low Risk” and “Quality”…but also one that rhymes with the “now” dynamic, as “Value” (Cyclical and Defensive) outperforms “Growth”.

It’s surely too early for equities to anticipate the next round of easing. We remain long Quality both Growth and Defensive, as well underweight equities in general.

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