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Omicron triggers higher volatility and equity profit taking: November 2021 Monthly Market Commentary

Market Context: Omicron triggers higher volatility and equity profit taking

Global Macro:  Global markets have reacted swiftly to the new Omicron variant, with an equity market sell-off in end-November. Nonetheless, economic growth remains strong around the globe amid central banks’ accommodating monetary policies, which we believe will support equity markets as countries and businesses adapt to a post-Covid world. We note corporate earnings are on the rise in the US, Europe, and China, with Chinese industrial firms’ profits surging 42.2% YoY to RMB 7.2tn in January-October 2021. Meanwhile, inflation remains high in Western economies (6.8% in the US; 4.9% in the Eurozone), in contrast to major Asian economies (2.3% in China; 0.1% in Japan). This may lead to a de-synchronization of central banks’ policies next year, which we think would favor Asian markets that will be less exposed to domestic rate hikes. We note the US Federal Reserve has already started its tapering by reducing its monthly bond purchases by USD 15bn, while the ECB and BoJ confirmed their easy monetary policy would remain unchanged for the time being.

Financial Markets:  We anticipate some market volatility going forward, which will provide opportunities. After falling 4% on average in November due to concerns over the Omicron variant, we believe equity markets will benefit from the global economic growth and rising earnings amid a favorable interest rate environment. On the fixed income side, although the Fed started to tighten liquidity, we think the US is unlikely to let its cost of funding increase much. Based on our econometric model, over the next 12 months, we expect to see the effective Fed funds rate (currently 0.07%) within the [0.10%; 0.50%] range, the 10-year US Treasury yield (currently 1.53%) within [1.3%; 2.0%], the 10-year German Bund yield (currently -0.40%) within [-0.4%; +0.2%], and the 10-year Chinese government bond yield (currently 2.90%) within [2.8%; 3.2%]. Meanwhile, we expect RMB to remain strong versus USD and other major currencies, on the back of China’s solid economic fundamentals and its relative resilience to the Omicron variant thanks to the country’s zero-Covid tolerance policy. We believe USD will continue to benefit from its safe-haven nature versus EUR, GBP and commodity currencies, like AUD and CAD, until we have more clarity about the toxicity of the Omicron variant. We also expect EUR and GBP to remain under pressure in the short term as Europe fights the new Covid wave.

Equity: Month to date the S&P 500, Euro Stoxx 50, and Hang Seng Index lost 0.7%, 4.5%, and 7.5%, respectively, amid increased market uncertainty and equity profit taking. Fixed Income: The 10-year US yield contracted 3bps in November to 1.53% as investors favored Treasuries over equities; meanwhile, the negative Covid backdrop resulted in a decline in Emerging Market government bonds (-2.6% in USD; -3.1% in local currencies) and High-yield corporate bonds (-3.1% in USD; -0.6% in EUR). Currencies: With respect to USD: EUR -1.7%, AUD -5.0%; CNY +0.4%; safe-haven JPY +1.0%, CHF -0.3%. Commodities: Gold edged up 0.5% in November while oil prices dropped 18.3%, amid concerns over the new Omicron variant.

Risks: 

  • Omicron variant: New waves of infections caused by the Omicron variant could weigh on the economic growth outlook.
  • Sustained inflation: Lasting inflation would induce central banks to tighten their monetary policy earlier than expected, leading to higher interest rates and a compression of equity stock valuations.
  • Supply chain disruptions: Further disruptions caused by the Covid pandemic or political sanctions would weaken the economic recovery.
  • Commodity price surge: Commodity mining and supply chain disruptions as well as the lack of new investment in energy sectors like oil over the past five years are causing supply to lag demand, leading to rising prices and contributing to higher inflation.
  • US tech bubble & corporate tax hike: Tech stocks remain under pressure, given the highest valuations since the dot-com era and high market concentration, while we expect the Biden administration to challenge tech companies’ light taxation and push through anti-trust legislation in the US.
  • US-China tensions: US-China trade frictions remain strong, with increasing tension around Taiwan and the South China Sea. In addition, the US is increasing pressure on Chinese companies listed on US stock exchanges by implementing stricter rules targeting Chinese firms, effectively leading to the delisting of Chinese stocks from US exchanges in favor of Hong Kong and Shanghai. We expect this to result in increased volatility in the coming months.

Opportunities:

  • Hedged bond income portfolios: As interest rates will likely trade in a range over the next 12 months, we highlight the importance of receiving positive carry (income from bonds or money markets) in fixed income portfolios with bond capital gains contributing less to fixed income portfolio returns. As the next move for rates is most likely on the upside, reflecting bond buying tapering from central banks, partial hedging of bond portfolios will be key to optimize risk-adjusted returns.
  • Chinese equities: The Chinese stock market has underperformed Western equities by c.45% this year amid US-China tensions and increased Chinese regulation on tech firms, with Chinese tech stocks plunging over 40% since January. However, we think the downside risk from here is moderate as the Chinese market starts to rebound and US hedge funds and asset managers are building long positions again.
  • Financials: We believe the financial sector will benefit from higher yields and a steeper yield curve when long-term interest rates eventually rise, but also from stronger growth via a reduction in nonperforming loans and the positive impact from lower loan provisions on earnings revisions. This would be positive for both the banking and the insurance sectors, where valuations continue to look attractive. We think stocks of well-capitalized quality banks in the US, Europe, Hong Kong, and Japan will pay above-market dividend yields following their central bank’s green light.
  • Oil & Gas: The energy sector is a major beneficiary of the global recovery, while long-term anticipated oil demand remains robust. Moreover, we are seeing increasing interest from investors towards major energy players that are implementing green energy programs to transition from fossil fuels to clean, sustainable energy production, thus making them major decarbonization contributors.
  • Nuclear energy: We believe the nuclear sector will be instrumental in the world’s decarbonization efforts. To achieve fossil fuel reduction targets, the nuclear power industry’s safety standards need to be brought to the next level, for instance by using new technology to recycle uranium. New “green” nuclear energy is the number one priority of President Macron in France, while being high on the agenda in the US and China, which will build 150 nuclear power plants in the next 15 years.