Staying invested amid new virus strain

A new, highly contagious, virus strain could trigger growth downgrades, worsen risk sentiment and have significant sectoral impact. We are concerned about the human toll and expect renewed restrictions on activity. We still favor equities for now, but would change our stance if vaccines or were to prove futile. If they are effective, the strain only delays the restart oftreatments economic activity, and we would lean against any stock market pullbacks. Less growth now means more later.

Low rates, for real

U.S. and German 10-year government real bond yields, 2011-2021

News of a contagious new virus strain called Omicron and an ongoing COVID surge in Europe have hurt risk sentiment. We see this affecting services dependent on economic activity, but are less concerned about the broad macro picture for now. Vaccine campaigns so far have proven effective and versatile. It would be a game changer if the new strain were to significantly compromise vaccine effectiveness and question the restart, but there is no evidence of this yet. Government restrictions will be lighter and more targeted than previous lockdowns, we believe, and their effect on economic activity has been waning as the world has adapted. See our COVID-19 tracker for the latest trends. Most importantly, we still see negative real, or inflation-adjusted, yields supporting equities. Real yields had edged up before the virus news but are still hovering near record lows, as the chart shows. The reason is a more muted response to inflation, thanks to fiscal–monetary coordination to bridge the virus shock and central bank policies of letting inflation run a bit hot. We expect real yields to rise from here, but stay at historically low levels in the inflationary environment. This makes equities valuations look better than they otherwise would, and challenges cash and nominal bonds.

The emergence of Omicron caused government bond yields to fall sharply late last week, but we believe the direction of travel is still up. We see the Fed starting to gradually raise rates in 2022 as the economy no longer requires stimulus - assuming the virus strain does not derail the economic restart. This would push yields higher across the spectrum, keeping the outlook challenging for nominal bonds. We believe equities offer higher risk-adjusted returns and a potential buffer against inflation risks – especially as we see rates rising less than in previous hiking cycles – and less than markets expect.

We recently stress-tested this thesis as risks have risen that policymakers or markets misread the current spike in inflation. Inflation expectations could spiral upward or, conversely, central banks could tighten prematurely. Both scenarios would suggest higher policy rates than our base case, and spell trouble for both stocks and bonds. If the Fed were to react to inflation just like it has done in the past, it would start raising rates much faster and to a higher level than markets currently expect. This would abruptly end the monetary and fiscal policy revolution that has brought about massive debt levels and a higher tolerance for inflation – and turn us neutral on equities on a strategic horizon, as we explain in our latest Portfolio perspectives publication for professional investors.

We don’t think such a scenario is likely, as it would require the Fed to abandon or completely reinterpret its new policy framework. What really matters for long-term investors is the sum total of growth and rate increases, we believe, rather than the individual parts or timing. This applies to both COVID-related risks that slow the restart and to the Fed’s rate trajectory. It’s why our core strategic asset views - a broad preference for equities over nominal government bonds and credit - have remained stable through the noisy restart. Importantly, we see government bonds offering less portfolio diversification against equity selloffs than in the past at their historically low yield levels. 

The bottom line: Omicron could trigger growth downgrades, worsen risk sentiment and hit services sectors, especially in the near term. It could even question the restart if vaccines or treatments were to prove ineffective. If they are effective, the new strain only delays the restart, and we don’t see it changing the otherwise solid picture for equities: a powerful restart and the prospect of continued low real rates. We are leaning against COVID-related stock pullbacks for now as a result. 

Assets in review
Selected asset performance, 2021 year-to-date and range

Market backdrop

Stocks and bond yields fell on news of the new virus strain late last week. Earlier in the week, yields had risen after Jerome Powell was nominated to a second term as Fed chair and Fed board member Lael Brainard as vice chair. This prompted the market to price out more dovish policy under a Brainard Fed. We expect the Fed’s interpretation of its employment objective to determine the timing of the kick-off on rates and their pace. We see inflation dropping from current levels and settling at a level higher than pre-COVID in 2022, as we expect a historically muted policy response to inflation.

Week ahead

Nov 30 – China manufacturing PMI, euro area HICP flash, U.S. consumer confidence
Dec 1 – U.S. ISM manufacturing PMI
Dec 3 – U.S. unemployment rate and non- farm payrolls

U.S. payroll and unemployment data will be in focus this week, given the labor market’s relevance for the Fed’s rate decisions going forward. The Fed’s inflation target has been met, so now the key is how the Fed will interpret the other side of its mandate – full employment. The timing and trajectory of rate increases will depends on this. We see the Fed raising rates only in the middle of 2022 and expect a shallower rate path than in the past as part of a more muted response to inflation.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, November 2021

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, November 2021

Download the full commentary