What Does Omicron Mean For Markets?

Friday’s equity market sell-off was the worst of this year so far, though following on seven weeks of straight gains for US equities, arguably long overdue. In addition, the 50% plus spike in the Vix volatility indicator gives a sense of the market surprise at news of a new COVID variant (Omicron), at a time when markets broadly were focused on the risks of rising inflation.

The sell-off, occurring on a half trading day, saw an outsized reaction to Omicron – oil falling heavily, ten year bond yields dipping below 1.5%, and the risk management stress of this may well carry on through Monday’s session. From this point there are likely three scenarios for the equity market into 2022.

Scenario 1: March 2020

The Omicron variant proves to be more resilient and deadly than other variants, and evidence builds that it has spread across Europe. The UK has already tightened travel conditions and other countries follow suit, leading to a disruption in economic activity and the risk of a European recession, at a time when China’s economy is already suffering. Markets are unprepared for the this and central banks perceived to have little room for manoeuvre. This is obviously bearish and at current valuations could trigger a deep correction towards 4200 on the SPX, with other equities, commodities and crypto all suffering as well.

Scenario 2: 5000

Investors soon wake up to the fact that South Africa in particular has an advanced rare and infectious diseases medical capability, and that while the number of COVID cases is rising quickly, deaths are still close to minimal. Vaccines can be adapted to tackle the new variant.

Also markets grasp that the short-term effect of the Omicron scare will be to reduce inflation in a few months time (ie lower oil prices, lower air fares) and this helps to keep bond yields low. If evidence of the spread of Omicron in Europe is scant, then markets are likely to retrace their loses and once into December the aggressive flow of funds into markets means that investors start to think in earnest of the 5,000 level on the SPX.

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Scenario 3: Noise

There is little immediate evidence of the spread of Omicron, but it proves a wake up call, and broadly speaking health and precautionary measures are intensified across Europe and the USA. It is also a wake up call for investors in terms of positioning, and of the lack of room for manoeuvre of central banks. Set against this is the growing recovery in the developed world and of the possibility that China acts to stimulate its economy. As such markets stay flattish into the end of the year but volatility subsides.

My sense is that the second and third scenarios are more likely, which gives some upside from here to year end, once volatility abates.

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