Friday’s equity market sell-off was the worst so far this year, though arguably long overdue, after seven weeks of straight gains for US equities. Furthermore, a more than 50% spike in the Wicks Volatility Indicator gives a sense of market surprise at the news of a new COVID variant (Omicron), at a time when markets were largely focused on rising inflation risks.
The half-trading day’s sell-off saw an outsized reaction for Omicron – oil fell heavily, ten-year bond yields fell below 1.5%, and its risk management tensions could well continue through Monday’s session. Is. From this point there are likely to be three scenarios for the equity market in 2022.
Scenario 1: March 2020
The Omicron variant proves to be more resilient and lethal than other variants, and creates evidence that it has spread throughout Europe. Britain has already tightened travel conditions and other countries follow suit, threatening a disruption in economic activity and a European recession, at a time when China’s economy is already suffering. Markets are not prepared for this and central banks are believed to have little room to maneuver. It is clearly bearish and at current valuations there could be a deep correction towards 4200 on the SPX, with other equities, commodities and cryptos all suffering as well.
Scenario 2: 5000
Investors soon wake up to the fact that South Africa in particular has an advanced rare and infectious disease therapy potential, and that while the number of COVID cases is rising rapidly, the death toll is still near a minimum. Vaccines can be adapted to deal with the new version.
At the same time, the markets understand that the short-term effect of the Omicron fear would be to moderate inflation (ie lower oil prices, lower airfares) over a few months’ time and help keep bond yields low. Markets are likely to recoup their losses if there is little evidence of Omicron’s spread in Europe and an aggressive inflow of funds into the markets once December means investors start thinking about the 5,000 level on the SPX. Huh.
Scenario 3: Noise
There is little immediate evidence of Omicron’s outbreak, but it proves to be a wake-up call, and health and precautionary measures have been intensified across Europe and the United States. It is also a wake-up call for investors in terms of the situation and lack of space for central banks to maneuver. Against this is the growing recovery in the developed world and the possibility of China stimulating its economy. Such markets tend to flatten out towards the end of the year but the volatility is reduced.
My understanding is that the second and third scenarios are more likely, which gives some upside from here to the end of the year, once the volatility is gone.