Is it an ominous sign that social media posts focused more on the process for naming the latest iteration of COVID, than it did debating the risks associated with the transformative mutations unique to Omicron?
The World Health Organization (WHO) classifies COVID variants with letters from the Greek alphabet in much the same way as we categorize hurricanes alphabetically. The idea is to provide the general population with a down-to-earth classification that simplifies the scientific designation and removes any stigma caused by referencing variants using the location where they were detected.
It is this process that caught the attention of social media influencers. By classifying the latest variant as Omicron, Internet pundits noted that WHO skipped over the letter’s “nu” and “xi.” According to WHO, the decision to skip “nu” was to avoid confusion with the word “new,” and “xi” was passed because it is a common name. Not to mention Xi is the first name of China’s leader for life.
So much for the name referencing quirks. The more serious question is how much of an impact this latest variant will have on global economies? To that question… analysts are divided! Experts have advanced potential risks all of which are shrouded in uncertainty.
The bears point to Singapore doctor Leong Ham who lamented during an interview with CNBC Asia Street Signs that “Omicron will dominate and overwhelm the world in three to six months.” He also believes that new vaccines targeting Omicron are a “nice idea” but will not be practical because of the transmissibility of the strain. And while experts do not know exactly how contagious the highly mutated Omicron variant is, Dr. Ham notes that the virus’s spike protein, which binds to human cells, has mutations associated with higher transmission and a decrease in antibody protection.
With more than thirty mutations related to the spike protein, there is concern that Omicron may be able to evade vaccines. The pharmaceutical industry is already sequencing the Omicron variant and is preparing to alter MRNA protocols to elicit an Omicron specific blueprint. But that takes time… three to six months as a best guess!
On a more positive note, an Omicron specific vaccine may not be necessary. There is no definitive evidence that Omicron can evade the protection afforded by current vaccines on a mass scale. There is also a train of thought that boosters will provide sufficient protection to reduce the risk of serious outcomes.
Keeping with that theme, it is important to recognize that elevated transmissibility will not, by itself, cause governments to shutter the economy. Potential shutdowns and travel restrictions are tied to the level of stress within the health care system, which is determined by both the percentage and absolute number of new cases that require hospitalizations.
Anecdotal evidence to date seems to suggest that Omicron infection results in mild cases with limited hospitalizations. According to Dr. Angelique Coetzee, who chairs the South African Medical Association, the nation’s hospitals were not overwhelmed by patients infected with the new variant, and most of those hospitalized were not fully immunized. Most patients did not lose their sense of taste and smell and had only a slight cough.
Weighing in on the bullish side, Pershing Square Capital Management founder Bill Ackman noted that “while we do not have definitive data, early reporting suggests that the Omicron virus causes ‘mild to moderate’ symptoms (less severity) and is more transmissible,” Ackman said in a recent tweet. “If this turns out to be true, this is bullish not bearish for markets.”
Still Omicron’s discovery has prompted considerable panic across the globe, with a number of countries banning flights from southern Africa, or — like Israel, Japan, and Morocco — barring entry of foreign travelers altogether.
Further stoking the fear gauge, Regeneron said its COVID antibody treatment might be less effective against Omicron, an indication that the popular and widely beneficial monoclonal antibody drugs may need to be updated if the new variant spreads aggressively.
There are also early indications that Omicron can reinfect people more readily. If so, it draws into question whether herd immunity is achievable. That said, Omicron’s emergence is so recent that it may be a while before experts know whether it is more pathogenic. COVID hospitalizations lag new infections by two weeks or more.
The word of the day is caution as there is no firm evidence that Omicron is more dangerous than previous variants. Delta quickly became the dominant global strain because it was more transmissible. And while there is evidence that Delta can cause severe illness in the unvaccinated, there is little data to suggest it is more lethal or capable of outsmarting vaccines.
We are watching science work in real time. Knowledge about the genetic makeup of this new strain will increase exponentially in the coming weeks. For now, there is no reason to believe Omicron is impervious to existing vaccines – Pfizer recently claimed their MNRA booster has so far proved highly effective. While vaccines may turn out to be less protective, 50% to 70% immunity is better than no immunity.
OMICRON’S IMPACT ON FINANCIAL MARKETS
Analysts blamed the recent swoon in financial markets on the Omicron surge coupled with a fifth wave of Delta infections across Europe. Amid the European responses so far, Austria re-introduced shutdowns and will be mandating vaccines in January, and Germany put in place major restrictions for the unvaccinated and is considering a vaccine mandate in early 2022.
On this side of the Atlantic, market participants were spooked by the new variant’s potential to threaten the U.S. economic recovery; a position echoed by Federal Reserve Chairman Jerome Powell in his Senate testimony.
The Fed believes Omicron complicates the inflation outlook. That combined with a tight labour market, is why Fed Chairman Powell abandoned the “transitory” reference believing that elevated prices could linger “well into next year.”
The degree to which global economies will be affected rests on whether we see inflationary fallout from Omicron. As mentioned in previous reports, most manufacturing hubs in the Asia Pacific basin have a zero COVID strategy that sets in motion immediate shutdowns when a cluster of cases appear.
If Omicron is more transmissible, any sign of new infections would result major distribution centers shutting to halt the spread of new cases. These shutdowns skew global supply chains, resulting in supply – demand imbalances that feed into the inflation cycle.
An Omicron surge can influence domestic labour markets as well. If people are nervous about going back to in-person jobs, it will take longer to unclog bottlenecks. As competition for labour intensifies, corporations increase wages. Higher wages get passed through to the end consumer which, in the worst case, could result in a 1970’s style wage price spiral. At a minimum, wage increases are difficult to reverse and, as such, are not transitory.
Throughout 2021, US stocks (as measured by the S&P 500 composite index) have racked up breathtaking numbers, and we are not looking for a repeat performance in 2022. Positive single digit return is our base case, and that does not account for COVID surprises.
The principal driver for equity markets in 2022 will be tighter monetary policy and higher interest rates. These factors that will have a bearing on the relationship between fixed income and equity assets, which will temper upside momentum.
As for Omicron, it may cause investors short term angst that may or may not translate into significant price adjustments. For example, in early 2020, when it was clear that COVID-19 would be a one in 100-year pandemic, economies were shuttered, equity markets suffered one of the steepest declines in history and central banks printed money at an unprecedented rate.
During the second wave of the pandemic – September to November 2020 – equity markets gyrated but did not collapse. When Delta emerged in May 2021, global equity markets suffered bumps but continued climbing a wall of worry.
There was weakness in global equities from late September through early October 2021, but that was the result of the hawkish rhetoric coming from central banks aimed at ratcheting down stimulus measures, not any news about COVID case counts.
Trying to assign any short-term directional bias given the limited knowledge we have about the Omicron variant is impossible. Mild cases so far are positive. The variant’s ability to re-infect is a huge negative.
Reinfection and transmissibility will determine the short-term path of least resistance for stocks. What we can say, is that uncertainty leads to increased volatility that will continue into the new year.
Throughout 2022, equity markets will be influenced by labour conditions, supply-chain disruptions, inflation concerns and interest rate fears. All factors that will have far greater impact on the stock market than weighing the short-term risk of hypothetical outcomes around Omicron.
Shorter term, say through 2021 yearend, investors will be subjected to above average volatility. That said, we remain in a long-term cyclical bull market and sell-offs should be viewed as buying opportunities.
It is that latter point where the rubber meets the road. You either fear volatility or use it to your advantage.
A TIMELINE FOR RISING INTEREST RATES
The consensus among economists is that the Bank of Canada (BoC) will raise interest rates by the end of the third quarter next year. There is a contingent among the group polled that believe the initial rate hike could come as early as April 2022.
The hawkish tone that seems to be permeating among central bankers reflects a change of thinking regarding inflation. “Transitory” is no longer the principal catch phrase as most bankers believe that inflation will remain above target for longer than originally expected.
The change in messaging from the BoC can be traced to the upswing in the Canadian labor market. The Canadian economy added more than 150,000 jobs in November, the unemployment rate fell to 6% which is just slightly above the pre-pandemic numbers. Since May, the Canadian economy has added more than 750,000 jobs. We now have more employed Canadians than prior to the pandemic. One could reasonably argue that the Canadian labour market is at full employment. At a minimum, it has fully recovered from the pandemic.
The October BoC quarterly economic review continued to promote the position that above-trend inflation was propelled by distinct economic headwinds. The BoC argued that while wages were rising, the economy was not operating at anything near full capacity, and that modest wage demands demonstrated there was slack in the labor market.
The transitory thesis was based on the position that the main contributor to inflation was supply chain bottlenecks that would eventually work their way through the system. If inflation instead moves to being propelled by wage expectations, as we believe it is, that has longer term implications.
We note, for example, the rising productivity gap. Employee output has not kept pace in percentage terms with the growth in employment. Output measures the amount of Gross Domestic Production (GDP) per hour of work. According to Stats Canada, private labor output declined 1.5% between the second and third quarter of 2021. That gap in productivity increases unit labour costs – i.e., wages and benefits – as a percentage of GDP.
Normally output gaps occur in the late stage of a recovery, when the economy is operating at full capacity with little slack in the system. One explanation for the current output gap is that companies, wanting to circumvent potential labour shortages as the economy re-opens, have ramped up hiring to stay ahead of the curve. That strategy may be premature.
Whatever the reason, when productivity wanes at the early stages of a recovery it has a much bigger and longer-term impact on inflation. Certainly, it will impact inflation beyond a transitory timeline associated with supply chain issues.
Ultimately, wage growth serves as the critical trigger for inflation as an economy approaches full capacity. For that reason, the labour and wage numbers must take precedence over capacity measures for the BoC, as crunch time approaches for the Bank to start raising interest rates.
If the BoC is going to stay on top of the inflation wave, it is the fast-disappearing labour gap, not the output gap, that should concern it the most.
DID FATHER KNOW BEST?
Does holding one stock in a portfolio ever make sense?
When you look at the mega-rich there is a common theme. Their wealth was fueled by the performance of a concentrated position in a single stock (Bill Gates, Steve Jobs, Elon Musk, Jeff Bezos), a significant sector bet (Donald Trump in real estate, Hunt Brothers in oil), or through a small basket of well managed companies (Warren Buffet and Berkshire Hathaway).
Beyond the ultra-rich, we have witnessed similar stories where above average wealth was created from concentrated positions, which begs the question: “is this a reasonable approach for average investors?”
To that point, I am reminded of an email I received in 2007 from – let’s call him Mr. DC. He wrote the following: “I had been a believer in asset and geographic diversification until this fall. As executor of my father’s estate, I noticed he had 60% in fixed income (corporate bonds and preferred shares) and 40% in equities. So far so good! However, I was shocked to find that his 40% equity stake was invested in a single stock… Royal Bank.”
Against all odds his father had no diversification within his equity mix, although his asset mix was balanced between fixed income and equity assets. Interestingly, Mr. DC did some research on his father’s portfolio and found that his dad had owned Royal Bank since 1983. Royal Bank had a 14% return over the previous ten years and had generated an 11.5% annualized return over the previous twenty-five years. And that did not include dividends.
Maybe father knew best!
Interestingly, I had penned a column in January 2005 entitled Why Own Banks? In that article I was addressing a specific reader’s equity portfolio that was concentrated in the banking sector. Just as with Mr. DC’s dad.
As I wrote then, and continue to believe, nothing in the investment business is absolute. As a portfolio manager who believes in modern portfolio theory, it would never be prudent to invest the bulk of one’s assets into a single sector or most certainly, a single stock. That said, it is hard to argue against banks as a long-term investment.
I recall a famous quote from the notorious bank robber William Sutton. When captured by the FBI the agents asked why he targeted banks? Mr. Sutton replied: “because that’s where the money is.”
Mr. Sutton knew what most investors have come to know instinctively… banks deliver! And the numbers are staggering. One study that came out around the time of the January 2005 article was presented by Andrew Guy, Associate Director, Portfolio Advisory Group, ScotiaMcLeod.
Mr. Guy researched Bloomberg statistics and determined that one dollar invested in the TSE 300 (S&P/TSX Composite) Index in 1956 would have been worth $17.29 at the end of March 2005. That represented a 6.1% annual return. However, that same dollar, had it been invested in the Financial Services Index in 1956, would have been worth $41.14 at the end of the same period.
Add dividends into the mix and the numbers are even more dramatic. Over the 1956 to 2005 period, $1 investment in the TSX Composite Index, with dividends reinvested, would have grown to $89.69 (vs. $17.29 price only). The Financial Services Index, with dividends reinvested, would have grown to $342 (vs. $41.14 price only).
Today you can purchase exchange traded funds that focus specifically on the banking sector. Looking at the accompanying chart, it is notable that the iShares Financial Services ETF (symbol: XFN) has outperformed the broader S&P TSX 60 Index ETF (Symbol: XIU) since its 2001 launch date. Again, not including dividend re-investment.
No matter how you look at it, banks have fattened the pocketbook of many long-term investors. Canadian banks have a virtual monopoly, can manage earnings using multiple levers, and continue to pay healthy dividends that are likely to increase their dividends at double digit rates for the foreseeable future. Not to mention recent announcements that significant share buybacks will take place over the next three to five years.
Any investment advisor who recommends selling banks invites performance comparisons down the road that, based on history, would favor the banks. But if we are to apply portfolio theory, you cannot escape the fact that banks are a sector within the economy with risks that are unique to that sector. Sector exposure tends to ramp up portfolio risk, and portfolio management is all about reducing risk.
And there lies the rub! Presumably Mr. DC’s dad was comfortable holding a single bank stock. That so-called comfort factor is critical within the context of a long-term investment strategy. Stated another way, it is the raison d’être for developing diversified portfolios.
From a financial perspective, getting an investor from where they are to where they want to be requires a good portfolio that has a good probability of delivering an appropriate long-term rate of return. Any well thought out package of securities will get you to where you want to be. The trick is managing the ride there.
A diversified portfolio will smooth out bumps that a more concentrated basket will experience. To make the point, look at the previous chart and ask yourself if you could withstand the downside volatility that occurred during the 2007 through 2009 great recession and through the first quarter of 2020, as COVID was shuttering economies. The problem is that most investors cannot withstand that degree of volatility, often exiting positions at exactly the wrong time.
Apparently, Mr. DC’s dad was able to withstand excessive downside volatility. Presumably, although we will never know for certain, he believed that the world was not coming to an end, and that eventually stalwarts of the Canadian economy would recover. As they did and will continue to do so.
Perhaps it is not a question whether father knows best. It is a recognition that father was able to withstand the risks inherent in a non-diversified approach. Making Mr. DC’s father a rare individual.
Richard Croft, Chairman & CIO