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Weekly investment update – The new Covid variant and the Fed-ECB policy divergence

Equity markets fell sharply after news of the latest Covid variant, Omicron, raised concerns about renewed lockdowns hurting economic growth amid uncertainty over its transmissibility and the efficacy of vaccines.  

It will take some weeks to identify the impact of the variant. Governments have reacted quickly – with many re-imposing travel restrictions such as halting flights and restoring border entry curbs, and implementing mandatory testing, quarantining and partial lockdowns.

Even before Omicron, financial markets already faced concerns in the form of inflation and central bank policy risk. Now, there is more uncertainty over whether equity markets could survive another Covid hit on growth with less central bank support.

Meanwhile, central banks have to deal with developments that appear to call for conflicting policy action, namely intensifying inflation pressure that could require tightening and rising Covid risk that could require easing.

The Fed has a dilemma

The US Federal Reserve’s policy is at an inflection point, requiring it to balance its three criteria for making rate rise decisions after the initial lift-off 

  • Maximising employment
  • Keeping inflation at 2% over the long term
  • Allowing inflation to moderately exceed 2% in the short term. 

The recent surge in consumer price inflation to its highest since the 1990s on the back of mixed labour market indicators – weak labour participation and strong wage growth (Exhibit 1) – are making this balancing act precarious.

Exhibit 1: Mixed signals – US labour participation is weak, but wages have rebounded

Data as at 21 November 2021, sources: Haver, BNP Paribas Asset Management

The new Covid variant is complicating things for the Fed. On the one hand, it could prolong supply-chain disruptions, thus adding to inflationary pressures. On the other, it could delay the reopening of the economy, leading to weaker growth and employment.

Under these circumstances, the voice of recently appointed Fed Vice-Chair Brainard could gain prominence. She appears likely to set a higher bar for meeting the maximum employment target than outgoing Vice-Chair Clarida. That could affect the perceived rate rise timetable.

If Omicron turns out to be relatively vaccine-resistant, it could slow economic re-opening, making it a dovish factor for policy even as persistent supply disruptions keep inflation high.

Until recently, falling real yields and a strong growth recovery propelled US stocks higher. Now, unless the tightening hawks at the Fed retreat, a bearish flattening of yield curves and pressure on growth shocks under the new Omicron outbreak could threaten equities if rates rise.

ECB doves have the upperhand

The ECB is facing a different set of macroeconomic conditions. A eurozone rate increase looks a long way off due to more lacklustre growth despite higher inflation (Exhibit 2). Although the market expects the ECB to end the Pandemic Emergency Purchase Programme (PEPP) in March 2022, its Asset Purchase Programme (APP) will likely continue, perhaps at a higher purchasing pace.

Exhibit 2: Eurozone inflation spikes higher

Data as at 21 November 2021; sources: Haver, BNP Paribas Asset Management

Inflationary momentum in the eurozone appears to be weaker than in the US, with more subdued wage and consumer demand growth. ECB President Lagarde has rebuffed strongly (but not convincingly enough for many market players) the expectation of rate increases in 2022 to quell fast-rising prices.

All of this points to a significant divergence between Fed and ECB policies in the coming year. Still, just like the rest of the world, Europe is facing a new Covid risk. This leaves future policy paths, be they dovish or hawkish, susceptible to change even in the near term.

Omicron in Asia – Will vaccination limit the impact?

The emergence of Omicron also poses a near-term risk to Asia’s outlook. To fight the pandemic, Asian policymakers have tended to rely more on targeted, selective lockdowns rather than full-blown ones.

Compared to the outbreak of the Delta variant in Asia in mid-2021, vaccination levels in the region are now much higher. Out of the 12 economies, 10 already have at least 70% of their population inoculated with one dose. The downside risk to growth may thus be less than the region faced in mid-2021 if the new variant is no more problematic than Delta.

Market estimates on the Omicron impact differ across the region. China, Hong Kong and Taiwan have maintained their zero-Covid policies. This should limit the near-term economic impact, but would also delay any reopening efforts and a rebound in consumption growth.

Australia, Japan, South Korea and Singapore have started to adopt a living-with-Covid strategy. However, the new variant could intensify pressures on hospital and ICU capacity. It could also prompt a rollback of reopening measures. Hence, these economies are exposed to a higher risk of a growth setback than the three China-related economies mentioned above.

The Indian and ASEAN economies have tried to tighten restrictions when cases rise sharply. If the latest variant is as challenging as Delta proved to be, there is a high risk of more lockdowns that could hurt economic growth more significantly than in the rest of the region.

From a supply perspective, experience shows that the disruption risk was higher in India and ASEAN. During the Delta wave, for instance, production in India and ASEAN was disrupted more than in North Asia. We could be set to see a repeat of that pattern.

Overall, the drag on Q4 2021 GDP in the region should be limited because the number of initial cases has been relatively low. If the variant slows the economic reopening and prolongs supply-chain disruptions, the growth risks will show themselves in the first quarter in 2022, with the ultimate effects depending on the evolution of the outbreak.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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