Is Omicron different for markets?

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Here’s a chart of the S&P 500 over the past year. Can you pick out the market sell-off during initial Delta variant scare? Do you even remember when it happened? No checking Google, you cheaters.

It happened in July. You can see it under the question mark in the chart’s title. Our last experience with a viral variant caused a little blip that we have all but forgotten four months later.

Back then, investors spooked by lockdowns fled travel and energy stocks for greener pastures such as Moderna and Kroger. Oil took a tumble and the yield curve flattened before snapping back. Investors began pricing in fewer future rate hikes, betting on lower-for-longer monetary policy. And within a week or so, markets had largely shaken off the whole incident.

The patterns established in July reasserted themselves last week. Moderna is topping the S&P 500 again. Oil plunged almost $10 a barrel on Friday (though some of the losses were recouped when futures markets reopened late Sunday). The yield curve is flattening. Investors are now expecting an average 2.1 rate hikes by the end of 2022, down from 2.8 earlier last week, according to Bloomberg. If the Delta template holds, markets are primed for a nervous week followed by a sturdy bounceback.

There is another reason to look past Friday’s big sell-off. The Omicron news has hit the most important global market — the US’s — as it is near all-time highs, fuelled by resurgent economic growth and, perhaps more to the point, wildly exuberant animal spirits, as Unhedged detailed last week. Every measure of sentiment is hot, from survey data to options market action. It stands to reason that such a market should be sensitive to bad news. It hasn’t priced in any.

The limited long-term market repercussions of Delta, as well as the natural jumpiness of today’s market, makes us sympathetic to the pithy summary of Barry Norris of Argonaut Capital, quoted in the FT on Friday: “The knee-jerk reaction is too obvious a trade. Next week a vaccine company will say their jab works on the new variant and you’ll get whipsawed all over again”.

So Unhedged has not fallen into its usual wild-eyed paranoia. But there are at least three reasons to think this time might be different from July.

The monetary and fiscal policy contexts have changed. US policy rates were pinned to zero when Delta hit and are in the same place today. But the tapering of QE is afoot now and policy rate increases are on the horizon, even if Omicron (in the view of the market) could delay or temper both processes somewhat. The crucial difference is inflation, which the Fed and central banks globally will have to watch closely, however the medical situation evolves. They will not want the current “growthflationary” environment turn into a stagflationary one.

It is not clear whether another major Covid-19 wave would be inflationary or deflationary. The sudden drop in energy prices will initially be deflationary. Energy prices contributed 1.8 points of the 6.2 percentage point annual increase in consumer price inflation in October. But in the longer term the question is whether an Omicron wave would depress demand or supply more, which would depend in turn on regional infection rates and policy responses. As Paul Ashworth of Capital Economics sums up:

With China intent on maintaining its draconian zero-Covid policy, the early speculation that the Omicron variant could add to inflationary pressures, by exacerbating existing supply chain problems, is understandable. But it is far too early to tell whether supply will be more affected than demand. In a worse-case scenario where Omicron proved to be vaccine resistant and highly transmissible, full [US] lockdowns — at least in the Northeast and California — can’t be ruled out, in which case the resulting slump in demand would be the dominant disinflationary effect.

This last summer when the Delta scare first hit, many Americans had received stimulus checks just a month or two before, and others were still receiving special Federal unemployment benefits, which expired in September. Prospects for further fiscal support in the face of another outbreak seems pretty dim. Ed Mills, policy analyst at Raymond James, put it to me as follows yesterday:

The last fiscal response followed lockdown and other Covid-related policies, and because Republican governors are less likely to respond than they were in March of 2020 — fewer governors will issue shutdown orders, fewer businesses will close — the pressure for a fiscal response will be lower . . . Covid has been politicised, so shutdown orders and fiscal responses have also been politicised. Things will have to get bad before the federal government responds.

Mills also points out a procedural hitch. If the Democrats decide to go ahead with further fiscal support in response to an Omicron outbreak, without any Republican support, they can only do that using budget reconciliation, and that can only be done once per budget proposal. For this fiscal year, however, reconciliation is already being used to push through Biden’s “Build Back Better” bill.

The second go-around with a significant variant could have a different effect on demand, sentiment, and workforce participation because it could begin to look as if the emergence of dangerous variants is a pattern set to repeat indefinitely. As Simon Quijano-Evans of Gemcorp sums it up, the problems are two:

1) Society in the northern hemisphere has decided it doesn’t want to fully vaccinate itself, and 2) Society in Africa doesn’t even have the luxury to decide whether it wants to be vaccinated, given it has been denied the full access to vaccines.

The vaccine companies say they can start turning out a vaccine for a new variant in just a few months. But as long as regions with low vaccination rates (Africa, Alabama) are operating as de facto variant development labs, the vaccine makers seem unlikely ever to get ahead of the game.

It felt for a moment there like we were in the late innings with Covid. What happens to the economy if there is a collective realisation that we are in the middle innings at best? The question is pressing in the US, where strong consumer spending is keeping the economy humming despite lousy consumer sentiment. Another dark Covid winter might bring the two together, and not in a good way (data from the Fed):

The health impact of the variant could be different. The World Health Organization thinks risks of reinfection from Omicron could be higher than the previous variants, and the news that two flights from South Africa to the Netherlands contained 13 patients who tested positive for the variant is certainly spooky. There are three cases in the UK already. It would be surprising if the variant will not be found on every continent in the coming weeks. The key questions are severity of infections and the efficacy of existing vaccines (and the new small-molecule treatments) against them. It’s pointless to speculate on the range of possible outcomes. But of course the medical reality is much more important than the economic and policy contexts.

One good read

An excellent survey by my FT colleagues of the political and economic complexities facing the gambling industry in Macau, and interesting microcosm of the Xi government’s policy agenda.

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