Volatility returned to the markets as Omicron, a new variant of Covid, scared investors. With 50 alterations, including 33 on the spike protein, the markets looked for clues to its contagiousness, lethality and efficacy of vaccines and treatments. Several countries have reintroduced travel restrictions, increasing the downside risks to growth. In a year when market performance has been solid, this heightened uncertainty has prompted a rapid adjustment of portfolios to preserve annual returns.
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At the moment we do not have enough information on this new variant to have a definitive view on its impact. However, our initial analysis of market movements leads us to believe that investors overreacted to Omicron's potential negative impact. In fact, contrary to previous concerns related to Covid, the sale was indiscriminate, with issues oriented towards the reopening of economies that had an equally negative trend as the securities that had benefited from the lockdowns. Furthermore, for the moment, the Delta variant remains the main problem, especially in Europe, where the main countries are reintroducing restrictions that should limit mobility and dent consumer confidence. For now, our baseline scenario after Omicron is one of moderate impact, which is likely to hinder but not derail the economic recovery.
Europe has now come to a point where mandatory vaccination is being discussed, as evidenced by what is happening in Austria, by the ongoing discussions in Germany, as well as by Ursula von der Leyen calling for an EU-wide discussion on ' subject. Regardless of any ethical discussion, and limiting itself to the impact on the market, mandatory vaccination would be a potential strong windfall for risky assets, as it would significantly reduce the likelihood of another round of restrictions.
However, what really caught our attention is the tightening of tone initiated by Fed chairman Jay Powell when he ditched the term "transitional" for inflation in his speech to Congress. Given the uncertainty surrounding Omicron's potential impact on business, the timing and speed of this major shift are odd, marking a significant shift in the Fed's assessment of the trade off between inflation and growth. What is surprising is not so much the need to normalize. In fact, Powell didn't add much to what he was already known for. Activity is buoyant, inflation is high and has spread beyond the volatile components. The brutality of the change of tone, however, marks a clear reorientation of the Fed's priorities (which, among other things, complicates things a lot for the ECB, given that the dynamics of inflation are different in Europe). Part of this reversal can probably be attributed to the fact that inflation has now become a political problem in the United States.
Midterm elections are scheduled for 2022, and curbing inflation was likely central to President Biden's confirmation of Jerome Powell in his role. The point is that this change of tone comes at a time when Omicron could further cloud the Fed's visibility. On the one hand, the variant is weighing on energy prices (crude has lost more than 20% since late October), and it could be a global drag on activity, which should help limit price pressures. On the other hand, it has the potential to further increase supply chain pressures, especially given China's zero-tolerance Covid policy. This could prove inflationary, but for "bad reasons" that cannot be controlled by central banks.
For the moment, the Fed has indeed only gotten close to what the market had already predicted. The weaker-than-expected December labor market report (210,000 jobs versus 550,000 expected) and weaker hourly wage growth (4.8% per year versus 5.0% forecast) lead us to maintain our expectation of two rate hikes next year, starting in June. From an asset allocation perspective, the combination of Omicron and a tougher Fed does not derail our core scenario, which is a slowing but still solid business next year, with EPS growth rising remains in positive territory. While monetary normalization is gaining momentum, real rates will remain deeply negative, which should continue to favor equities over sovereign bonds.
Source: Lyxor AM, Allianz Research
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