29 Nov 2021
If we had to describe our approach in one line it is: to take on the emotional sources of volatility in markets. Stated differently where there has been an overreaction for reasons other than fundamentals. Of course, there can be an element of both. For example, our sense is that early evidence from the new Omicron variant from the South African health authorities is that infection severity does not appear to be particularly severe. However, we are probably still in the vacuum stage of information which is being filled (in a market sense) by investors’ prior convictions and behavioural biases. If the new variant is a lot worse than the initial observation, it is plausible that the market’s reaction was not emotional at all, but warranted. It might also be that the reaction was in response to the potential for more “bad” policy restricting freedom of movement and commerce. It is the case that China’s already-tight COVID policy appears unlikely to change in the near term.
From our perch, the other plausible explanation for the weakness in equities is that the timing of the new variant occurred just as the Federal Reserve (and other central banks) had commenced normalisation of liquidity (tapering) and the fixed income markets had priced higher short rate expectations in response to persistent inflation pressure. Put another way, policy makers might still be boxed into removing policy accommodation in spite of the new potential impact on mobility. It is also the case that the fiscal impulse will fade over the coming quarters as well and become a drag on growth next year and equities face a deteriorating growth-inflation mix.
On the positive side, macro conditions in the United States were very strong ahead of the latest variant scare. As we noted last week, US retail sales and final demand is well above trend. The labour market has also largely recovered with initial unemployment claims at a 50 year low, albeit that has yet to be fully reflected in total employment. In contrast, EM and Asian assets have been quietly, but steadily bleeding in the background. Our sense is that has clearly been a function of the credit (policy) induced slowdown and growth scare in China which has materially under performed the region this year. The good news is that the rate of change in China’s credit growth is probably near a trough and financial conditions have started to ease.
The other positive point to note is that Asian markets are at inexpensive valuations on an outright basis and back at 1997-2002 levels relative to the S&P500. While the outright multiple could de-rate further if the growth scare deteriorates, the relative gap with the United States has never been greater (chart 1). Equities sensitive to the cycle and re-opening were also already weak leading into this episode which appears inconsistent with US fundamentals. To be fair, renewed restrictions on mobility and commerce might exacerbate that trend in the short term. Even if the Omicron variant proves to less dangerous, it might damage macro conditions by slowing the re-opening of global trade and commerce.
In conclusion, our sense is that the recent price action probably is an emotional overreaction relating to the new variant, but the withdrawal of liquidity was a genuine challenge for equities prior to this episode. The prospect of a faster reduction in QE and higher short rate expectations relative to prior beliefs was probably the greater challenge facing beneficiaries of low rates and super-abundant liquidity. Of course, it is also possible that Omicron reduces central bank hawkishness in the near term. The good news for Asia is that the region has already lagged due to weakness in China and credit conditions. On the positive side, that should improve over the coming months from a low base. Moreover, valuation in Asia is considerably less expensive than it is in the United States. We have modestly increased long equity exposure into this episode via our Asian Tech basket. We also used this opportunity to broaden the basket and add more of the “platform” stocks in China.