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Market volatility is back

The Fed and the Omicron variant are taking us for a bumpy ride. Can the economy withstand a pullback?


Our Top Market Takeaways for December 3, 2021.

Markets in a minute

Two cross-currents are behind a volatile week

Two of the risks we flagged in our 2022 Outlook, the ongoing pandemic and monetary policy, were behind a volatile week in markets.

On the virus, there is still more unknown than known about the Omicron variant. Though there is little evidence that it is more dangerous than previous variants, particularly for vaccinated individuals, we still don’t know for sure. We also don’t know whether or not it is more transmissible than the original strain or variants such as Delta. Further complicating matters, messaging from vaccine and therapy producers is mixed. Moderna thinks the efficacy of its vaccine may be diminished against the variant. Pfizer seems more hopeful, and it should have data-driven results on potential vaccine efficacy in a few weeks.

Markets didn’t wait around to find out the answers. Assets that are sensitive to travel were under pressure for most of the week. The global airline ETF has lost over -8% since Black Friday. Cruise lines have lost around -15%. Crude oil is down around -15%, and is now over -20% below peak levels reached in October.

Notably, “stay-at-home” stocks didn’t do well either. Zoom has lost -20% this week. Netflix has lost -7%. The market is clearly nervous about Omicron, but if the only fear was whether we’d spend this winter at home, then you’d expect names that might benefit to hold up better. This means there was probably more to the story than just the new variant.

Cue Fed Chair Powell. At his Senate testimony on Tuesday, he acknowledged that inflation seems likely to run hotter for longer, and retired the use of the word “transitory” to describe it. More importantly, he signaled that the Federal Reserve may opt to accelerate its announced pace of tapering to end its asset purchase plan by spring rather than summer. This is what it sounds like when [monetary policy] doves cry.

In the aftermath of the announcement, 2-year Treasury bond yields rose above 60 basis points, close to their pre-Omicron peaks, while 10-year Treasury yields fell. This “curve flattening” (when short-term rates and long-term rates converge) is seen as a sign that markets are starting to price in a tightening cycle that could pinch economic growth.

Are we worried about the implications of a possibly faster taper? Not yet. A few reasons why:

  1. The broad economy doesn’t need ongoing asset purchases to sustain its expansion. The Fed purchases assets to help make sure liquidity keeps flowing through the economy’s plumbing. Asset purchases are a form of active stimulus. Now that the broad economy has fully recovered and moved into expansion, asset purchases aren’t needed to ensure smooth market functioning.

  2. Faster tapering doesn’t necessarily mean faster rate hikes. The Fed has communicated that rate hikes will be on the table once tapering is complete, not sooner. To us, the potential acceleration of tapering simply gives the Fed more flexibility to maneuver policy in the year ahead.

    Let’s say the Fed does announce a tapering acceleration at its December meeting. Then, if inflation is still running alarmingly hot by spring, the Fed has the ability to deliver a rate hike to try to cool things off. Alternatively, if inflation is showing signs of sequential cooling, the Fed can bide its time as more data (particularly on the labor market) comes in and shows further progress toward its other goal of maximum employment.

  3. We think the economy can handle higher rates anyway. Even if the Fed delivers the two rate hikes the market is expecting next year (which is more than our base case calling for one), borrowing rates adjusted for inflation still wouldn’t be high enough to disincentivize investment throughout the economy. Given our expectations for productivity increases, we think the economy will be able to handle higher interest rates before they start to make the expansion sputter.

But a less supportive Fed still has very important implications for investors. When monetary policy gets less supportive, the most speculative stocks can be the first ones to crack. Remember how stay-at-home winners had a bad week even though Omicron risk is rising? A less friendly Fed probably has a lot to do with that.

In fact, this trend has been happening under the surface for quite a while. The chart below shows the peak-to-trough drawdown of a few assets that were hot at one point this year, and of broader indices. The message: As we move further into the cycle, and tighter monetary policy starts to become a reality, we think it will benefit to focus on quality companies.

This week’s silver lining is that, despite Chair Powell’s saber-rattling on inflation, it seems a little less likely now that the Fed will actually have to end up tightening monetary policy aggressively. The froth in equity markets continues to wane. Energy prices (including crude oil and natural gas) are down almost -25% from the end of October, and market-based inflation expectations are solidly in line with the Fed’s target. There are still acute price pressures in areas such as automobiles, but shipping costs continue to moderate, suggesting some reprieve in supply chains. Omicron complicates things, but we still believe patient policy will support risk assets, and that COVID-19 will continue to have a diminishing impact on markets and economies throughout 2022.

For more, be sure to read our full Outlook for 2022.


All market and economic data as of December 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

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