News of a newly identified Covid-19 variant, Omicron, started to emerge on mainstream media last week. Scientists have indicated it will take roughly two weeks to establish current vaccine effectiveness against Omicron. During this time no one can say with surety what the situation will look like, even one week from now.
Mutation uncertainty caused riskier asset prices (equities) to decline and safe assets (government bonds) to rally: For the most part, markets err on the side of caution when uncertainty is elevated. In the mainstream media, the tendency to focus on areas that are losing out prevailed. They almost always forget to balance out negatives with positives. We thought we should redress some of this imbalance.
As mentioned, in response to the unwelcome news about Omicron, equities fell but bond prices rose (this also means bond yields are now lower than they were). Chart 1 provides a visual representation of the price action. The inference from this is that investors in general believe Omicron will have exert a negative influence on future economic growth.
In the chart we plot the FTSE 100 price index against the price of 10-Year Gilts over the past 10 days. This captures the point before and after news of the mutation emerged. As you can see the price moves are almost a perfect mirror image. Economists have a term to describe such movements – negative correlation.
Chart 1: FTSE 100/10 Year Gilts, 17 Nov 21 – 01 Dec 21
Source: Bloomberg, 2021
When something alters to disturb the status quo in the macro economy, such as a new virus mutation, context matters. Therefore, it is important to re-examine some of the key driving forces impacting the economy; and how they could shift in response to changes in the growth outlook.
Over the past 2 years major developed economies, such as the UK and the US, have benefitted massively from cheap finance. Over a very long period bond yields in each country have fallen, but in the last couple of years they reached all-time lows; with some countries, Japan and in Europe, issuing negative yielding sovereign bonds. This has allowed governments to borrow and spend to support their economies.
Prior to uncertainty about how the new mutation will impact growth we know inflation had been rising sharply and the cheap, long term, financing opportunity that governments have been exploiting threatened. There was also a great deal of chatter about the need for short term interest rates to rise. However, if growth does slow, because of the uncertainty being experienced, it seems more possible interest rate rises will be pushed out a little farther, and long-term bond yields may continue to be capped until there is a clearer line of sight on what will happen to demand. This could extend the cheap borrowing window for governments and help to constrain the effects until pressures ease.
Outside of the major developed markets we also know the Chinese economy has been recently struggling to maintain growth. The authorities there have restricted access to credit and introduced increased regulation into their technology sector, causing ructions in their stock market. With growth faltering and a new virus threat on the horizon China is known to have significant fiscal and monetary firepower to deploy. It seems more likely than not that they are primed and ready to unleash monetary and fiscal stimulus into their economy should this be needed.
If we look back over the past 15-years (See Chart 2) China’s spending cycles have a stop-go pattern; indicating it could be ready to “go” very soon!
Chart 2: China Credit Impulse (% YoY)
Source: Bloomberg, 2021
Finally, one area of the market where the public will be happy to see prices drop is oil. This essential commodity has been adding pressure onto the inflationary environment, and threatening demand. Fuel and plastics have become more and more expensive, and the energy component of company input costs have soared putting pressure on them to raise the price of goods. However, prior to the virus mutation news, the US government announced they will release 50 million barrels from their strategic petroleum reserves putting supply related downward pressure on WTI and Brent Crude. With an added concern about the future path of demand, the price of each has now dropped by over 20% to around $66 and $69 a barrel respectively.
Chart 3: WTI/Brent Crude Price, 19th Nov 21 – 03rd Dec 21
Moreover, there is more supply to come. OPEC+ agreed to keep the planned January output rise of 400,000 barrels a day, adding more oil despite concerns that economic growth may be reduced due to the impact of the Omicron variant around the globe. History tells us that while oil prices can be inflationary, the main influence it imparts is a tax on consumers. Therefore, a falling oil price is like a consumption tax cut and once implemented we all feel a bit better off.
Key summary points:
- The volatility in riskier asset markets is being offset to an extent by sovereign bonds acting as a stabilising force. Interest rate expectations are shifting farther out and monetary conditions will remain loose.
- China’s slowing economy could be turned around with sizeable monetary and fiscal stimulus. This will boost global growth.
- The sharp rise in fuel prices seen over the past few months may be showing signs of easing generating a sigh of relief for many who have struggled with the inflated costs of travel and energy. Again, another demand led boost to economies.