Markets’ omicron pivot underlines value of diversification

What did we learn this week?

Omicron’s emergence reignited COVID-19 fears given early signs the new variant may be more effective at evading existing vaccines.

Jerome Powell was nominated as Fed Chair for a second four-year term over the more dovish Governor Lael Brainard, who will become vice chair. The FOMC minutes showed some support for a faster tapering of bond purchases.

US labor and consumption data were strong. Weekly jobless claims fell to 199,000, the lowest level since 1969. Consumer spending jumped 1.3% in October, more than double September’s rise. Core PCE inflation reached 4.1% in the 12 months to October, the highest since 1991.

How do we interpret this?

Concerns about the omicron variant’s potential impact on global GDP growth prompted a sell-off in risk assets on Friday: The S&P 500 fell 2.3%, the largest one-day decline since October 2020. The 10-year Treasury yield fell 16 basis points, while the VIX index jumped 10 points to 28. Markets went from pricing 2.8 Federal Reserve rate hikes in 2022 to 2.1.

A period of market volatility after such a strong rally should not come as a major surprise. But it does serve as a reminder of the value of being diversified across markets and sectors.

Markets pivoted last week from concerns about premature Fed policy tightening to renewed fears about the pandemic. We expect further volatility in the near term as investors assess shifting risk factors:

• We advise investors against jumping to conclusions based on small data samples with potentially large margins of error. We share markets’ concern over the emergence of the new COVID-19 variant and will monitor developments closely. However, given currently available information, our base case is that the omicron variant does not warrant a change in our view that the global economy is on a (bumpy) road to full reopening and that growth will be robust.
• Worries about COVID-19’s impact on the growth outlook should reduce investor concerns about premature tightening of monetary policy. Prior to the Thanksgiving holiday, investors had been focused on tightening financial conditions following elevated US PCE inflation data, a more hawkish shift in rhetoric from some Federal Reserve officials, and Powell’s renomination as Fed chair rather than the more dovish Lael Brainard.
• We don’t think the Fed will act hastily… The Fed is still wary of overtightening, and we see Powell’s renomination (assuming Senate confirmation) as a sign that his gradual approach will continue—especially if pandemic-related uncertainties persist. The FOMC minutes indicated a “number of participants” still prefer to be patient on tapering, and reiterated that rate hikes are not imminent. With the US economy reaccelerating in the fourth quarter—the Atlanta Fed’s GDPNow tracker is at 8.6% annualized—and corporate earnings robust, we don’t expect the withdrawal of monetary accommodation to derail the equity rally.
• …but gradual policy normalization should support further USD upside. The Dollar Index fell 0.7% on Friday alongside US yields. But the trend of global monetary policy divergence remains intact, and should support further upside for the US dollar over the coming year. Strong US economic data should allow the Fed to keep on course toward policy normalization, while other central banks—including the European Central Bank—keep policy loose for some time. We see EURUSD falling to 1.10 by end-2022.

What does this mean for investors?

We advise against hasty shifts in investment strategy and recommend staying invested. We still favor adding exposure to more defensive areas, specifically healthcare, which has a beta to the market of around 0.8 and was one of Friday’s better performers. Exposure to alternatives can also be helpful during periods of high volatility, including in hedge funds, many of which can outperform when equity markets are falling.

We position for further strength in the US dollar, and in other currencies exposed to more hawkish central banks (the GBP, NZD, and NOK), versus those where policy is likely to remain dovish (the EUR, JPY, and CHF).

While we expect further upside for global equities broadly, we see the greatest potential in markets that are well placed to benefit from global growth but are less exposed to concerns about policy tightening, such as the Eurozone and Japan. We also maintain our positive view on energy and financials despite the recent bout of volatility.

Visit our website for more UBS CIO investment views.

Please visit ubs.com/cio-disclaimer #shareUBS